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BANKING  AND   BUSINESS 


BANKING  AND  BUSINESS 


BY 

H.  PARKER    -.VILLIS,  Ph.D. 

Professor  of  Hanking,  Columbia   Unirersity 
Formeriy  Secretary,  Federal  Reserve  Board 

AX  I) 

GEORGE  W.  EDWARDS,  Ph.D. 

Assislaid  Professor  of  Bankiny 
School  of  Business,  Columbia   University 


■■•"•••     ■'/ 


47058 


HARPER    &    BROTHERS    PUBLISHERS 

NEW     YORK    AND     LONDON 
MCMXXII 


Banking  and  Business 


Copyright,  1922,  by  Harper  &  Brothera 
Printed  in  the  United  States  of  America 


CONTENTS 

o 

-a 

PART  I.— EXCHANGE 

f^    CHAP.  PAGB 

5{              Preface vii 

V          I.  The  Exchange  of  Goods 3 

II.  Credit  and  Banking 14 

III.  Credit  Instruments 28 

IV.  The  Field  of  Banking 46 


S  PART  II.— COMMERCIAL  BANKING 

V.  Bank  Organization  and  Administration   ....  59 

VI.  Bank  Operation 74 

VII.  Depositor  and  His  Bank 95 

VIII.  Financing  the  Business  Man 106 

IX.  Bank  Portfolios 131 

.^^         X.  Reserves 150 

-j       XI.  The  Bank  Statement 164 

,      XII.  Raies  of  Interest  and  Discount 185 

XIII.  Banking  Costs 200 

XIV.  Public  Regulation  of  Banking 213 

XV.  Interbank  Relations 234 

XVI.  Foreign  Exchange 252 

XVII.  Financing  Foreign  Trade 270 

XVIII.  Banking  Methods  in  Foreign  Countries      .    .    .  285 


i 


PART  III.— NONCOMMERCIAL   BANKING 

XIX.  The  Investment  Bank 299 

XX.  SA\^NGS  In.stitutions 311 

XXI.  Trust  Companies 333 


CONTENTS 

PART  IV.— THE  BANKING  SYSTEM 

CHAP.  PAOB 

XXII.  Types  of  Banking  Systems 353 

XXIII.  Banking  Abroad 369 

XXIV.  Evolution  of  the  American  Banbiing  System    .     .  389 
XXV.  Organization  of  the  Federal  Reserve  System      .  414 

XXVI.  The  Federal  Reserve  System — Its  Operation     .  440 

XXVII.  Government  and  Banking 462 

XXVIII.  Prices,  Money,  and  Banking 478 

XXIX.  Economic  Significance  of  Banking 499 


LIST  OF   APPENDICES 

I.  Definitions  of  Credit 515 

II.  Operations  of  Commercial  Banks 517 

III.  Commercial  and  Investment  Banking        ....  521 

IV.  Limitations  on  Loans  by  National  Banks    .     .     .  525 
V.  Interbank  Loans 527 

VI.  New  York  Call-money  Market 531 

VII.  Statements  of  Foreign  Banks 541 

VIII.  Questions  and  Answers  Relating  to  Membership 
OF  State  Institutions  in  the  Federal  Reserve 

System 548 

IX.  Selected  List  of  Collateral  Reading      ....  560 

Index 563 


PREFACE 

In  this  volume  the  authors  have  undertaken  to 
present  an  outUne  of  modern  American  banking  in  its 
relation  to  other  business.  Their  intention  has  been 
to  prepare  a  university  and  college  text  that  would 
be  of  service  in  teaching  those  elements  of  banking 
which  are  most  needed  in  the  schools  of  business  and 
commerce  now  in  process  of  development  at  many  of 
our  universities.  The  arrangement  of  topics  and  the 
general  direction  of  the  discussion  corresponds,  broadly 
speaking,  to  the  organization  of  the  work  in  the  intro- 
ductory course  in  banking  in  the  School  of  Business 
of  Colmnbia  University. 

The  teaching  of  banking  in  American  colleges  and 
universities  has  for  many  years  past  been  closely  asso- 
ciated or  combined  with  instruction  in  the  theory  of 
money.  Most  college  courses,  we  believe,  are  desig- 
nated as  courses  in  "Money  and  Banking."  A  cus- 
tomary way  of  presenting  the  material  is  t<D  begin  \xith. 
a  historical  survey  of  the  growth  and  development  of 
money,  followed,  perhaps,  by  a  sketch  of  the  credit 
instruments  which  have  in  later  years  superseded  it  as 
mediums  of  exchange.  This  is  followed,  as  a  rule,  by 
chapters  deahng  with  the  theory  of  money,  prices, 
and  the  broader  or  more  doctrinal  side  of  the  study. 
Banking  is,  in  man}^  instances,  dealt  with  as  a 
derivative  of,  or  annex  to,  the  monetary  discussion, 
which  is  given  chief  place.  ]\Ioreover,  it  has  been 
the  practice  with  not  a  few  text  WTiters  to  direct  their 
attention  chiefly  to  the  more  theoretical  and  to  the 


viii  PREFACE 

historical  sides  of  the  subject  and  to  analyze  banking 
chiefly  as  a  pubUc  question. 

No  doubt  the  older  method  of  textbook  presentation 
has  its  merits,  since  otherwise  it  would  hardly  have 
continued  as  long  or  been  maintained  as  persistently 
as  has  been  the  case.  This  plan  is  not,  however,  suited 
to  the  requirements  of  those  who  are  pursuing  their 
studies  with  a  view  to  actual  business  life.  While  for 
such  students  it  is  essential  that  a  reasonable  basis  of 
theory  and  principle  should  be  afforded,  this  alone  will 
not  suffice,  but  it  must  be  accompanied  by  at  least  a 
general  outline  of  the  actual  methods  adopted  by  banks 
in  the  conduct  of  their  own  operations  and  by  exposi- 
tion of  their  relationship  to  other  types  of  business. 

Experience,  too,  seems  strongly  to  support  the 
thought  that  in  entering  the  general  field  of  monetary 
science  a  beginning  is  best  made  with  banking,  and 
that  that  subject  should  be  studied  largely  from  a 
descriptive  standpoint,  with  the  intention  of  conveying 
to  the  student  a  fair  outline  knowledge  of  the  bank  as  a 
working  institution — an  element  in  the  modern  business 
organization.  The  principles  of  money,  it  is  thought, 
should  be  introduced  incidentally  and  should  be  given 
a  relatively  secondary  place,  only  such  attention  being 
given  them  as  is  needful  to  explain  and  sustain  the 
discussions  of  banking  itself  by  which  they  are  pre- 
ceded. Debate  as  to  controverted  points  of  theory  and 
discussion  of  the  abstractions  of  monetary  science 
should,  it  is  believed,  be  largely  avoided,  while  the 
consideration  of  banking  in  its  public  or  legislative 
aspects  should  for  the  same  reasons  be  assigned  to  a 
secondary  position,  not  because  of  any  underestimate  of 
its  importance,  but  because  of  the  belief  that  this  is 
not  the  aspect  in  which  the  subject  appeals  most 
strongly  to  the  student  or  to  which  he  can  to  best 


PREFACE 


IX 


advantage  give  the  first  months  of  his  study  of  the 
subject. 

The  authors  have  therefore  endeavored,  in  this 
volume,  after  the  first  preliminary  and  general  ideas 
have  been  considered,  to  introduce  the  student  to  the 
current  organization  and  business  practice  of  com- 
mercial banks.  In  so  doing,  moreover,  it  has  been 
sought  to  emphasize  less  the  internal  organization  of 
the  bank  itself  than  its  business  aspect  as  viewed 
from  the  outside.  Particular  attention  has  been  given 
to  the  financing  of  the  individual  enterprise,  the  prob- 
lems which  must  be  met  by  the  business  man,  in 
whatever  occupation  engaged,  in  connection  with  the 
transaction  of  the  banking  side  of  his  operations.  A 
succeeding  section  of  the  book  has  for  reasons  of 
convenience  been  devoted  largely  to  a  descriptive  out- 
line of  banking  in  various  aspects,  an  understanding  of 
which  seems  necessary  to  full  comprehension  of  present 
banking  problems  and  conditions,  although,  strictly 
speaking,  they  would  not  find  a  place  in  a  treatise 
upon  banking  in  the  commercial  or  narrower  sense  of 
the  term.  These  phases  of  the  discussion  having  been 
completed,  the  way  is  paved  for  a  relatively  brief 
outline  statement  of  the  relation  of  the  bank  to  the 
monetary  system  and  of  its  function  in  the  develop- 
ment of  prices. 

The  volume  as  thus  presented  embodies  material 
which  has  for  some  years  past  been  in  use  in  the 
School  of  Business  of  Columbia  University  in  the  form 
of  outlined  mimeographed  notes.  Owing  to  the  in- 
crease in  the  membership  of  the  introductory  classes, 
it  had  been  deemed  advisable  to  put  the  material  into 
printed  form,  and  eventually  it  was  determined  to  give 
it  a  more  formal  shape  as  a  textbook.  It  is  hoped  that 
the  volume  may  be  of  service  in  other  institutions 


X  PREFACE 

where  the  problem  of  teaching  banking  has  presented 
itself  in  somewhat  the  same  guise. 

In  the  preparation  of  the  volume  an  equal  division 
of  the  chapters  has  been  made  between  the  authors, 
but  the  final  text  is  the  result  of  joint  revision  and 
adaptation,  for  which  both  are  responsible.  Sincere 
acknowledgment  is  made  to  Dr.  W.  H.  Steiner,  As- 
sistant Director  of  the  Division  of  Analysis  and 
Research,  Federal  Reserve  Board,  for  many  valuable 
suggestions  in  the  shaping  of  the  volume. 

H.  Parker  Willis. 
George  W.  Edwards. 

Columbia  University,  December,  1921. 


Part   I 
EXCHANGE 


BANKING  AND  BUSINESS 

CHAPTER  I 

THE  EXCHANGE  OF  GOODS 

I.  Exchange  and  the  Division  of  Labor. 

If  we  glance  even  casually  at  the  modern  organiza- 
tion of  business,  two  features  or  elements  in  it  present 
themselves  as  of  striking  suggestiveness : 

1.  Few  persons  are  producing  articles  which  they 
themselves  want  to  consume  or  use. 

2.  Few  persons  sell  or  exchange  their  services  or 
products  directly  for  other  services  or  products  which 
they  wish  to  consume  or  use. 

It  is  true  that  there  are  exceptions  to  these  general 
rules.  The  farmer  may  raise  vegetables  for  his  own 
table  as  an  incident  to  staple-crop  farming.  The 
worker  in  a  shop  may  be  allowed  to  take  goods,  which 
he  wants,  from  the  stock  and  be  debited  with  them 
against  the  salary  due  him  for  services.  Many  other 
illustrations  of  direct  production  or  direct  exchange 
might  be  cited,  but  only  a  little  reflection  is  needed 
to  show  that  they  are  immensely  in  the  minority  as 
compared  with  the  general  body  of  business.  Men 
work,  but  not,  as  a  rule,  for  themselves;  they  trade, 
but  as  a  rule  for  things  they  do  not  want. 

The  facts  just  set  forth  lead  to  two  conclusioiLs  or 
inferences  which  follow  from  the  outstaiidinii;  facts  cited: 

1.  Business  to-day  is  dependent  upon  the  exchange 


4  BANKING  AND   BUSINESS 

of  goods  and  services.  Nearly  every  transaction  in- 
volves or  calls  for  a  process  of  sale  and  purchase. 

2.  This  exchange  must  be  carried  on  in  terms  of  some 
commodity  or  value  which  serves  as  an  intermediary 
or  as  a  step  from  one  to  the  other. 

The  intermediary  which  serves  this  purpose  is  what 
we  ordinarily  call  money;  the  process  of  sale  and  pur- 
chase referred  to  involves,  as  an  auxiliary,  the  operation 
known  as  banking. 

Reasons  why  the  exchange  of  goods  has  been  de- 
veloped into  an  indirect  or  roundabout  process  are 
usually  set  forth  by  economists  somewhat  as  follows: 

1.  Abilities  differ  widely  between  individuals. 

2.  Therefore,  the  largest  production  is  secured  by 
having  each  producer  devote  himself  to  that  article  in 
which  he  can  obtain  greatest  results. 

3.  The  process  of  production  is  facilitated  by  having 
articles  specialized  and  produced  upon  as  large  a  scale 
as  possible. 

4.  Hence  the  concentration  of  machinery  and  plants 
upon  individual  items  which  in  many  cases  have  no 
useful  purpose  except  as  parts  in  a  whole  that  is  to  be 
assembled  from  many  sources. 

5.  I'he  considerations  already  suggested  may  be 
summed  up  in  the  proposition  that  division  of  labor 
is  essential  to  and  the  basis  of  modern  industry. 

Division  of  labor  depends  upon  and  implies  exchange, 
which  in  turn  is  only  one  part  of  the  broader  field  of 
economics,  and  the  ancillary  processes  or  mechanisms 
already  referred  to. 

The  evident  importance  of  exchange  in  economic  life 
has  led  economists  to  assign  it  a  place  as  one  of  the 
four  fundamental  divisions  of  their  science,  which  are 
frequently  enumerated  as  production,  exchange,  dis- 
tribution, and  consumption.  Within  each  of  these 
general  grand  divisions  there  has  been  developed  a 


THE  EXCHANGE   OF   GCODS  5 

group  of  specialized  processes.  Under  the  heading 
"exchange"  there  are  thus  included  studies  relating 
to  the  mechanism  of  money,  prices,  banking,  as  well 
as  others.  Banking  is  thus  a  special  phase  of  the 
general  economic  process  known  as  exchange. 

n.  Evolution  of  Exchange. 

Exchange  takes  place  because  a  greater  amount  of 
values  can  be  produced  through  what  has  just  been 
termed  division  of  labor.  In  the  primitive  organiza- 
tion of  society,  division  of  labor  was  very  limited. 
Individuals  performed  each  for  himself  the  principal 
operations  necessary  for  the  support  and  improvement 
of  existence.  The  early  family  was  in  part  founded 
upon  primitive  division  of  labor  and  thus  had  an  eco- 
nomic side.  IModern  society  rests  fundamentally  upon 
a  very  high  development  of  the  division  of  labor. 
Specialization  in  production  renders  necessary  produc- 
tion on  a  large  scale,  and  large-scale  production  implies 
an  increasing  degree  of  speciahzation.  Commercial 
products  are  thus  widely  separated  from  the  con- 
sumers who  eventually  make  use  of  them.  This  fact 
necessitates  a  series  of  exchanges  of  goods.  Exchange 
is  thus  essential  to  the  organization  of  the  modern  world. 

Not  only  is  the  high  development  of  division  of 
labor  essential  to  modern  business  and  industry,  but 
it  is  also  true  that,  as  exchange  advances  toward  more 
and  more  complex  stages,  the  ascertainment  of  \'alue 
or  the  rate  at  which  commodities  shall  exchange  for 
one  another  becomes  more  and  more  difficult.  So  long 
as  a  given  product  can  be  more  or  less  directly  con- 
nected with  the  use  to  which  it  is  to  be  put,  there  is  a 
subconscious  measure  of  its  exchange  value  which  at 
least  serves  as  a  regulator  or  controlling  factor.  When 
the  item  produced  finds  its  value  only  as  an  incident  in 


6  BANKING  AND   BUSINESS 

production  of  some  far  more  highly  compHcated  article 
— as,  for  instance,  in  the  case  of  fuel  used  to  operate 
spinning  and  weaving  machinery — this  indirect  utility 
measure  of  exchange  value  disappears  or  becomes  so 
vague  as  to  be  unavailable.  The  modern  process  of 
exchange,  therefore,  has,  as  a  secondary  reason  for  its 
existence,  the  necessity  of  determining  the  ratios  of 
exchange  of  goods  for  one  another.  The  ascertain- 
ment of  the  proper  price  of  an  article  and  the  adjust- 
ment of  that  price  in  such  a  way  as  to  permit  regular 
and  continuous  production  of  it  to  occur  in  the  desired 
quantity  is,  in  large  measure,  dependent  upon  the 
proper  operation  of  the  mechanism  of  exchange. 

Because  of  the  complexity  of  the  modern  exchange 
process,  there  has  developed  much  antiquarian  or 
historical  discussion  regarding  the  successive  steps  by 
which  the  use  of  money  was  brought  to  its  present 
status.  The  only  really  important  matter  in  this 
whole  historical  discussion  about  the  origin  of  money 
is  that  methods  or  processes  of  exchange  differ  and 
develop  from  period  to  period,  there  being  no  single 
or  universally  most  advantageous  way  of  exchanging 
goods.  What  is  desired  is  to  bring  about  their  move- 
ment from  producer  through  the  various  intermediate 
stages  to  the  consumer  with  as  little  friction,  cost,  or 
loss  as  may  be.  This  is  sometimes  effected  by  barter, 
although  as  seen  at  the  outset,  not  usually,  owing 
largely  to  the  inconvenience  of  barter.  It  may  some- 
times be  effected  by  sale  for  money  and  the  subsequent 
purchase  of  other  goods.  Sometimes  the  most  con- 
venient method  of  transfer  is  afforded  by  a  deferred 
exchange,  a  seller  waiting  for  the  return  of  other  goods 
(desired  by  himself)  by  the  trader  who  has  taken  his 
product.  This  kind  of  exchange  is  usually  termed  a 
credit  operation  or  credit  transfer. 

It  is  clear,  however,  that  in  every  condition  or  stage 


THE   EXCHANGE   OF   GOODS  7 

of  economic  life  there  is  a  kind  of  exchange  or  a  type 
of  trading  which  best  serves  the  needs  of  the  parties 
to  it,  or  the  needs  of  the  community,  or  both.  The 
function  and  duty  of  business  is  to  ascertain  how  such 
transfers  may  best  be  made  and  to  bring  them  to 
fruition.  The  fimction  of  banking  is  to  suppl}-  means 
of  actuall}^  consummating  the  exchanges  or  transfers. 

III.  Types  of  Exchange  Transactions. 

We  must  now  study  somewhat  more  anal}i:ically  the 
different  possible  types  of  exchange  to  which  reference 
has  been  made,  for  the  purpose  of  ascertaining  the  true 
significance  of  each. 

1.  WTien  a  producer  ceases  to  consume  his  own  out- 
put and  exchanges  it  for  the  output  of  another  similarly 
situated  producer,  the  operation  is  called  barter;  and 
the  goods  exchange  in  proportion  to  the  relative  neces- 
sities and  bargaining  power  of  the  participants. 

2.  ^\^len  other  producers  engaged  in  turning  out 
similar  goods  begin  to  participate  in  the  process  of 
exchange,  offering  their  goods  against  one  another  and 
competing  together,  a  market  is  established.  In  such 
a  market  where  competition  exists  values  tend  toward 
a  stable  or  uniform  level  and  the  power  of  one  com- 
modity to  command  others  is  called  its  purchasing 
power,  or  price. 

3.  When  a  commodity  is  offered  for  others  in  a 
competitive  group  of  the  kind  just  described,  resulting 
in  the  establishment  of  a  price,  this  price  is  usually 
expressed  in  terms  of  some  one  commodity  selected  for 
that  purpose  and  known  as  a  standard  of  value.  If 
this  standard  is  used  in  direct  exchange  for  other  goods 
it  may  be  termed  money.  In  that  capacity  it  has 
usually  or  sporadically  the  functions  of  standard  of 
values,   standard   of   deferred   payments,   medium   of 


8  BANKING   AND   BUSINESS 

exchange,  store  of  value,  and  others  which  may  be 
regarded  as  derivatives  of  these. 

4.  When  a  commodity  is  transferred  by  its  maker 
or  owner  to  another  trader,  but  without  any  direct 
payments,  the  transaction  is  said  to  involve  credit; 
and  a  credit  transaction  may  be  defined  as  an  uncom- 
pleted or  deferred  exchange  or  as  an  exchange  not  yet 
closed.  Eventual  closing  of  the  exchange  may  occur 
through  transfer  to  the  original  seller  of  other  goods  in 
an  amount  or  quantity  satisfactory  to  him.  A  credit 
transaction  may,  however,  be  stated  in  terms  of  money 
and  be  closed  by  the  return  of  a  specified  quantity  of 
money  regardless  of  the  power  of  such  money  to  com- 
mand other  commodities. 

5.  When  a  trader  both  buys  and  sells  on  credit, 
holding  himself  liable  to  those  with  whom  he  deals 
for  the  net  balances  due  them,  he  has  assumed  a  general 
credit  relation  to  the  community,  or,  in  other  words, 
he  is  carrying  on  credit  transactions  with  the  pubhc 
as  a  whole.  Such  transactions  constitute  banking,  which 
is  the  process  of  generalizing  credit,  clearing  or  canceling 
it,  and  so  effecting  the  final  exchange  or  redistribution 
of  goods.  In  commercial  banking  the  banker  carries  on 
his  dealings  solely  in  terms  of  money  and  usually  as- 
sumes the  obligation  to  furnish  money  to  any  customer 
on  demand  up  to  the  amount  of  the  latter 's  net  claim. 

IV.   Banking  Viewed  as  a  Phase  of  the  Theory 
OF  Exchange. 

In  the  past  there  has  been  a  disposition  among 
writers  on  the  subject  to  deal  with  banking  as  if  it 
were  in  some  way  an  expansion  or  application  of 
monetary  theory.  There  would  seem  to  be  little 
justification  for  this  view.  Banking  might  exist  much 
in  its  present  form  without  any  dependence  upon  the 


THE   EXCHANGE   OF  GOODS  9 

use  of  money,  while  theories  of  money  have  compara- 
tively little  bearing,  except  in  an  indirect  way,  upon 
theories  of  banking.  The  practice  of  viewing  banking 
as  a  phase  or  development  of  monetary  science  has 
tended  to  narrow  the  discussion  of  the  subject  and  to 
prevent  the  application  of  those  general  economic 
ideas  with  which  it  is  properly  to  be  grouped. 

When  banking  is  thought  of  as  a  specialized  mecha- 
nism for  the  excliange  of  goods,  and  when  the  theory 
of  banking  is  viewed  as  a  phase  or  element  in  the 
general  theory  of  exchange,  the  underlying  principles 
which  apply  to  it  become  clear.  They  a/e  essentially 
the  same  as  have  been  explained  by  the  economists  in 
their  analyses  of  exchange.  In  this  aspect  they  are, 
therefore,  familiar,  and  need  no  detailed  review  further 
than  the  mere  reminder  that  the  basis  for  a  sound  un- 
derstanding of  banking  is  found  in  the  analyses  of 
value,  particularly  of  exchange  value,  which  have  been 
recognized  by  economists. 

V.  Development  of  the  Credit  System. 

Viewing  banking  theory  as  an  element  in  general 
economic  theory,  the  reason  for  the  development  of 
banking  as  a  mechanism  likewise  becomes  plain.  It 
is  the  outcome  of  the  experience  of  other  methods  of 
exchange.  In  the  early  history  of  civilization,  there 
was  a  long  period  during  which  the  prhicipal  exchanges 
were  effected  by  means  of  barter.  This  period  was 
followed  by  another  during  which  money  exchanges 
came  in  to  supersede  barter  to  a  very  considerable 
extent.  Within  comparatively  modern  times  a  credit 
system  has  succeeded  the  systems  of  ancient  and 
mediaeval  times.  It  should  not  be  understood  from 
what  has  been  said  that  these  periods  of  barter,  money, 
and   credit   exchange   are   sharply   marked   off   from 


10  BANKING  AND   BUSINESS 

one  another,  or  even  that  they  shade  into  one  another 
by  imperceptible  degrees.  On  the  contrary,  the  facts 
in  the  case  seem  to  show  that  there  was  extensive  o\'er- 
lapping,  and  that  fairly  advanced  ideas  of  credit  were 
developed  quite  early  in  the  period  of  money  exchanges, 
while  barter,  as  is  well  known,  has  persisted  in  many 
parts  of  the  world  down  to  modern  times  and  has  even 
been  broadened  and  confirmed  since  the  close  of  the 
European  war  because  of  the  inadequacy  of  the  money 
and  credit  systems  of  Europe,  as  seen  in  the  shipment 
of  materials  from  the  United  States  to  Europe  and  the 
return  of  finished  goods  made  from  such  materials  in 
payment  therefor.  There  are  thus  no  distinct  "peri- 
ods," in  the  chronological  sense,  which  may  be  marked 
ofif  from  one  another  as  indicating  the  duration  of  the 
systems  of  barter,  money,  or  credit.  It  is  possible  to 
speak  of  "periods"  in  this  connection  only  in  the  sense 
that  the  predominant  characteristic  or  controlhng 
method  of  exchange  employed  at  any  given  time  may 
be  said  to  have  been  that  of  either  barter,  money,  or 
credit.  Speaking  in  this  restricted  sense,  it  is  fair  to 
regard  the  sixteenth  century  as  a  period  characterized 
by  a  wide  use  of  money,  while  the  nineteenth  century 
and  the  beginning  of  the  twentieth,  particularly  the 
years  after  1850,  was  essentially  a  credit  period,  and 
accordingly  a  period  in  which  banking  was  brought  to 
a  development  which  had  previously  not  been  known. 

VI.  Credit  as  a  Form  of  Exchange  Without  Money. 

The  term  credit  has  already  several  times  been  used 
and  a  credit  transaction  has  been  incidentally  defined 
as  denoting  an  uncompleted  exchange.  Since  modern 
banking  proceeds  upon  a  money  basis  in  the  sense  that 
the  banker  obligates  himself  to  pay  money  on  demand, 
the  practical  current  definition  to  be  given  to  credit 


THE  EXCHANGE   OF   GOODS  11 

should  be  that  of  exchange  in  which  no  money  passes, 
or  as  a  form  of  exchange  whicli  is  conducted  without  the 
use  of  money.  Objection  may  be  made  that  this 
would  admit  barter  transactions  which  in  no  sense  are 
credit  operations.  If,  for  example,  A  exchanges  skins 
for  grain  which  has  been  raised  by  B,  the  transaction 
is  closed  when  the  exchange  takes  place,  and  no  money 
has  intervened.  Narrowly  speaking,  therefore,  prim- 
itive barter  of  this  kind  would  be  included  within  the 
definition  of  credit  which  has  already  been  suggested. 
A  means  of  further  safeguarding  the  definition  might 
be  found  by  introducing  the  so-called  time  element  and 
regarding  credit  tran«^actions  as  those  that  are  closed 
only  after  the  lapse  of  a  certain  length  of  time.  Indeed, 
many  writers  on  the  subject  regard  the  time  element 
as  the  essential  or  characteristic  feature  of  credit. 
This  does  not  seem  to  be  a  well-warranted  view  of  the 
case.  As  will  be  seen  at  a  later  point,  many  transac- 
tions which  result  in  an  immediate  closing  of  obliga- 
tions contain  no  time  limit,  as,  for  example,  when  A 
purchases  goods  from  B  and  pays  B  with  a  check  on 
his  bank.  This,  as  will  be  seen  in  later  pages,  is  un- 
mistakably a  credit  transaction,  yet  it  involves  no 
postponement  of  settlement  as  between  A  and  B. 
Recognizing  the  possible  difficulties  to  which  the 
definition  is  thus  open,  the  idea  of  credit  as  a  system 
of  indirect  exchange  or  exchange  without  money — 
hence,  at  any  given  moment  uncompleted  exchange — 
is  accordingly  adhered  to. 

VII.  Definition  of  a  Bank,  Banking  System,  Credit 
System. 

A  commercial  bank,  for  the  purposes  of  the  present 
discussion,  is  an  institution  of  credit  or  an  institution 
whose  purpose  it  is  to  facilitate  or  effect  exchanges 


12  BANKING  AND   BUSINESS 

without  the  use  of  money.  Every  bank  maintains  a 
money  reserve  and  has  money  transactions  over  the 
counter.  It  is  not  true,  therefore,  that  it  carries  on  its 
business  without  the  use  of  money,  but  merely  that  in 
practice  it  reduces  the  use  of  money  to  a  minimum. 
Nevertheless,  it  remains  entirely  true  that  the  object 
of  the  bank  is  to  facilitate  exchange  without  the  use  of 
money — that  is  to  say,  to  provide  or  furnish  credit  as 
a  means  of  exchange.     It  is  a  credit  institution. 

Banking  and  credit  are  thus  the  two  correlative  ideas 
whose  analysis  and  treatment  should  proceed  together. 
The  ideas  of  money  and  monetary  science  should,  so 
far  as  practicable,  be  dissociated  from  the  discussion  in 
its  early  phases.  They  have  a  bearing  upon  it  which 
will  be  referred  to  at  a  later  point,  but  that  bearing 
is  only  incidental. 

By  a  banking  system  is  meant  the  relationship 
which  exists  between  banking  units  or  institutions,  and 
in  some  cases  the  mechanism  of  general  control  or 
union  between  banking  units  which  has  been  estab- 
lished by  law.  From  this  standpoint,  banking  legisla- 
tion or  banking  enactments  constitute  an  important 
element  in  the  banking  system  as  such. 

By  a  credit  system  is  ordinarily  meant  that  whole 
mechanism  for  exchanging  goods  without  money  which 
exists  in  any  community.  The  banking  system  is  the 
nucleus  of,  or  central  element  in,  the  credit  system. 
There  are  many  credit  transactions  which  take  place 
without  the  aid  of  banks,  but  the  banking  organization  of 
the  country  furnishes  the  underlying  means  of  Uquidat- 
ing  credit  and  of  settling  outstanding  obligations. 

VIII.  Commercial  and  Investment  Banking. 

Banking  may  be  recognized  as  distinguished  into 
two  separate  branches — commercial  banking  and  in- 


THE   EXCHANGE   OF   GOODS  13 

vestment  banking.  By  commercial  banking  is  meant 
that  phase  of  banking  which  has  to  do  with  short-term 
credits — credits  based  upon  or  intended  to  proA'ide 
for  the  exchange  of  goods.  By  in\'estment  banking 
is  meant  banking  which  has  to  do  with  credits  whose 
purpose  is  the  de\'elopment  of  production.  Through 
it  capital  goods  such  as  machinery  are  brought  into 
the  hands  of  those  who  will  use  them  for  productive 
purposes  as  well  as  goods  which  are  merely  destined 
for  resale  by  the  buyer.  It  thus  also  serves  to  supply 
business  houses  with  the  permanent  capital  they 
require,  while  commercial  banking  merely  supplies 
those  houses  with  this  working  capital  which  they 
need  for  temporary  purposes  and  expect  shortly  to 
repay.  Both  investment  banking  and  commercial 
banking  thus  bring  about  a  redistribution  of  the  capi- 
tal in  existence,  though  they  do  this  in  different  ways 
and  for  different  purposes. 


CHAPTER  II 

CREDIT  AND  BANKING 

I.  Differences    Between    Direct    and    Indirect 
Exchange. 

Accepting  for  the  moment  the  definition  and 
analysis  of  credit,  furnished  in  the  foregoing  chapter, 
the  question  now  presents  itself,  How  does  a  credit 
system  operate  or  in  what  way  does  it  differ  from  a 
system  of  direct  exchange?  It  is  clear  that  the  essen- 
tial difference  between  such  direct  exchange  and  the 
credit  or  indirect  type  of  transfer  is  found  in  the  fact 
that  the  parties  to  the  transaction  have  not  realized 
the  values  growing  out  of  it,  so  that  in  every  such 
transaction  there  is: 

1.  Uncertainty  of  actual  or  eventual  settlement, 
which  raises  a  question  of  security. 

2.  Uncertainty  of  payment  in,  or  convertibiUty  into, 
money,  which  raises  a  question  of  what  is  called 
liquidity  or  liquidating  power. 

II.  Classes  of  Credit. 

Writers  on  credit  enumerate  various  kinds  or  species 
of  credit,  including : 

1.  Personal  credit.     This  is   currently  taken   to 

mean  credit  which  effects  the  transfer  of 
goods  or  money  to  an  individual  on  his  mere 
assurance  and  without  security. 

2.  Commercial  credit.   This  is  probably  the  broad- 

est and  vaguest  term  currently  used,  but  is 


CREDIT  AND  BANKING  15 

frequently  taken  to  mean  credit  represented 
by  all  grants  of  time  within  which  to  settle  for 
merchandise  bought  at  wholesale  for  resale  or 
manufacture. 

3.  Mercantile  credit.     By  this  is  usually  meant 

credit  which  effects  the  extension  of  accom- 
modation by  retail  merchants  to  their  cus- 
tomers (consumers). 

4.  Bank  credit.    By  this  is  usually  signified  credit 

represented  by  loans  and  discounts  by  banks 
without  regard  to  use. 

5.  Public  credit.    By  this  is  ordinarily  indicated 

credit  represented  by  the  acK-ances  secured 
by  treasuries  through  sale  of  bonds  and  cer- 
tificates of  debt. 

Credit  here  is  defined  by  the  writers  referred  to  as 
operating  in  three  ways:  (1)  as  a  transfer;  (2)  as  a 
grant  of  time;  (3),  (4),  (5), as  a  loan, accommodation, or 
advance.  Upon  analysis,  however,  it  will  appear  that 
the  credit  transaction  is  at  bottom  the  same  in  these 
classifications,  and  that  the  distinguishing  elements  or 
points  of  difference  in  all  cases  center  about  the  two 
questions  already  referred  to,  the  various  classes  of 
credit  presenting  special  problems  under  these  two 
heads.  In  each  class  or  kind  of  credit  the  questions  at 
issue  are  simply  these:  Will  the  recipient  or  beneficiary 
of  the  credit  finally  close  the  transaction  as  agreed  by 
giving  value  in  settlement;  and  are  his  transactions  of 
a  kind  that  will  enable  him  to  complete  the  transaction 
as  expected?  The  process  of  measuring,  testing,  judging, 
or  apportioning  credit  is  a  process  of  determining  the 
degree  of  uncertainty  on  these  two  heads  that  is  present 
in  any  given  transaction. 


IG  BANKING  AND  BUSINESS 

III.  Classes  of  Credit  on  Basis  of  Time. 

There  is  a  classification  of  credit  less  popular  than 
that  just  given  whicii  presents  a  special  problem 
deserving  of  notice.  By  some  writers  credit  is  classified 
on  a  time  basis  thus: 

1.  Long-term  or  investment  credit. 

2.  Intermediate  or  productive  credit. 

3.  Short-term  or  commercial  credit. 

The  distinction  sought  to  be  established  here  is  a 
good  deal  more  subtle  than  that  which  is  suggested 
in  the  earlier  descriptive  classification.  The  underlying 
thought  in  it  is  that  the  term  or  period  for  which  credit 
is  granted  deeply  influences  the  character  of  the  use 
to  which  the  goods  are  put.  Thus  if  A  asks  for  a  ten- 
year  loan,  it  is  because  he  wishes  to  build  a  house, 
exploit  a  mine,  or  provide  a  permanent  supply  of  work- 
ing capital.  If,  on  the  other  hand,  B  borrows  for  thirty 
days,  he  can  have  no  intention  of  building,  mining,  or 
developing  a  property.  He  probably  borrows  in  order 
to  buy  ready  goods  for  a  quick  turnover  or  to  meet 
obligations  which  are  falling  due,  expecting  to  settle 
with  his  creditor  out  of  current  funds  to  be  paid  him 
within  the  month's  period  for  which  his  credit  runs. 
Accordingly,  say  the  advocates  of  this  view,  the  time 
element  is  the  real  or  true  determinant  of  the  character 
of  credit.  Long-term  is  essentially  different  from  short- 
term  because  of  the  different  character  of  the  purposes 
served  by  it. 

The  points  raised  with  regard  to  the  different  ends 
served  by  long  and  short  term  credits  may  be  freely 
accepted  without  altering  the  analysis  already  given 
v.'lth  respect  to  the  two  main  points  always  to  be 
considered  in  measuring  or  granting  credit.  There  is, 
however,  a  matter  involved  in  this  classification  which 


CREDIT  AND   BANKING  17 

must  receive  at  least  passing  notice.  This  is  the  funda- 
mental question  already  briefly  considered,  whether 
credit  is  essentially  a  question  of  time  at  all. 

IV.  Analysis  of  Time  Element  in  Credit. 

In  the  theory  of  credit  which  is  popularly  accepted 
by  the  greater  number  of  men  in  business,  the  idea  of 
credit  is  undoubtedly  associated  with  that  of  time. 
The  borrower  thinks  of  credit  as  a  means  of  postponing 
the  date  of  making  an  actual  payment.  Thus  he  speaks 
of  credit  extended  for  thirty  or  sixty  days  by  a  bank, 
or  he  says  to  his  customer  that  the  goods  may  be  taken 
on  a  credit  of  ninety  days.  This  concept  of  credit  as 
simply  a  means  of  postponing  the  date  of  settlement  is 
closely  associated  with  the  view  of  credit  as  a  loan  of 
money.  The  money  is  conceived  of  as  being  "bor- 
rowed" for  a  definite  period  during  which  it  is  used  in 
some  productive  occupation  resulting  in  a  profit. 
These  ideas  also  appear  in  a  more  or  less  modified  form 
in  much  of  the  theoretical  writing  found  in  economic 
works  on  capital  and  interest.  Indeed,  the  postpone- 
ment of  consumption  has  been  by  some  given  as  the 
real  reason  for  the  payment  of  interest.  An  o\\Tier  of 
capital  or  goods  is  conceived  of  as  desiring  to  consume 
immediately  the  articles  of  which  he  stands  possessed, 
as  being  induced  to  postpone  his  consumption  of  them 
by  the  pajonent  of  interest.  The  act  of  transferring 
the  goods  or  wealth,  or  in  some  cases  the  "money," 
to  the  "borrower"  is  viewed  as  a  grant  of  credit. 
Time,  in  short,  is  almost  universally  treated  as  a 
cardinal  factor  in  the  granting  of  credit. 

It  may  be  questioned  whether  this  view  affords  a 
sound  analysis  of  credit,  as  seen  in  connection  with 
banking  operations.     Without  attempting  to  discuss 


18  BANKING  AND   BUSINESS 

academically  the  theory  of  interest,  one  or  two  con- 
siderations bearing  upon  credit  are  worthy  of  special 
note.  We  have  already  defined  the  bank  as  a  credit 
institution,  or  institution  of  credit,  and  we  have  seen 
that  if  A  has  a  deposit  on  the  books  of  the  bank  against 
which  he  draws,  a  check  so  used  is  spoken  of  constantly 
as  a  credit  instrument,  and  the  transfer  made  is  a 
transfer  of  bank  credit.  From  another  part  of  our 
analysis,  it  will  be  plain  that  the  service  performed  by 
the  bank  in  granting  credit  is  that  of  examining  or 
testing  the  borrower's  assets  and  business  record  as 
shown  by  his  statement  of  condition.  Accepting  these 
views  of  the  character  of  credit  for  the  moment,  a  doubt 
is  raised  whether  the  service  of  the  bank  is  actually  a 
service  which  necessarily  involves  the  element  of  time. 
It  may  easily  be  that  a  customer  of  a  bank  obtains  an 
advance  from  it  which  he  at  once  transfers  to  another 
depositor.  The  outcome  of  the  transaction  then  is  to 
shift  the  credit  on  the  bank's  books  from  A  to  B,  and  so 
long  as  B  carries  it  without  using  it  it  may  be  conceived 
of  as  a  time  advance.  Even  though  A  has  parted  with 
the  credit  immediately  upon  getting  it,  the  bank  still 
continues  to  be  obligated  to  meet  it.  On  the  other 
hand,  B,  when  he  received  the  transfer  from  A,  may 
have  used  it  to  settle  a  previously  existing  debt  to 
the  bank,  so  that  the  credit  is  almost  immediately 
canceled. 

V.  Bank  Credit  as  a  Mechanism  of  Exchange. 

Suppose  we  generalize  this  view  of  credit,  remember- 
ing that  the  total  amount  of  bank  obligations  is  fairly 
stable,  and  that,  though  it  ma}^  increase  for  a  period  of 
months  at  a  time,  this  upward  movement  may  be  fol- 
lowed by  a  hke  period  of  decrease.  It  is  certainly  not 
an  unfounded  or  violent  supposition  if  we  regard  the 


CREDIT  AND   BANKING  lo 

total  volume  of  bank  credit  as  practically  stable  over  a 
considerable  period.  This  does  not  mean  that  no  new 
credit  is  granted.  It  merely  means  that  about  as 
much  is  being  canceled  as  is  being  granted.  Looking 
at  bank  credit  in  the  aggregate,  then,  it  is  not  an 
"extension"  of  loans  or  accommodation,  but  it  is  a 
steady,  consistent,  more  or  less  uniform  means  or 
machine  used  in  bringing  about  the  exchange  of  goods. 
With  a  certain  existing  level  of  prices  and  volume  of 
business,  a  given  volume  of  bank  credit  is  brought  into 
existence  or,  in  other  words,  a  given  number  of  solvent 
borrowers  present  themselves  to  banks  with  requests 
for  accommodation.  They  obtain  the  advances  they 
want  and  transfer  them  to  others  who  use  them  in 
canceling  already  existing  obligations.  If  it  ])e  sup- 
posed that  the  banking  system  of  a  country  is  practi- 
cally permanent,  then  the  outstanding  minimum  le\'el 
of  bank  credit  may  also  be  regarded  as  practically 
permanent.  It  is  a  permanent  mechanism  of  exchange 
and  not  an  "advance"  which  is  to  be  repaid  at  any 
given  moment.  From  this  standpoint  the  element  of 
time  seems  to  figure  but  little  in  the  fundamental 
analysis  of  bank  credit  transactions. 

If  bank  credit  is  not  primarily  dependent  upon  the 
idea  of  time,  what  is  the  characteristic  service  per- 
formed by  the  bank  which  permits  the  institution  to 
make  a  charge  for  the  work  it  does?  This  is  not  a 
service  of  "lending"  at  all  in  the  ordinary  sense,  but 
is  a  service  of  insuring  or  guaranteeing  the  existence 
of  values.  The  essential  function  of  the  bank  is  that 
of  making  sure  that  given  individuals  may  safely 
transfer  values  to  others.  The  bank  enters  in  as 
a  buffer  between  the  buyer  and  seller.  It  takes  the 
risk,  and  the  amount  which  it  charges  for  this  service 
is  more  nearly  in  the  nature  of  an  insurance  premiui  i 


20  BANKING  AND   BUSINESS 

than  it  is  of  a  pa3'ment  for  "abstinence"   from  the 
immediate  use  of  ''money"  or  even  of  "wealth." 

VI.  Relation  of  Bank  Credit  to  Money. 

Bearing  this  view  of  bank  credit  in  mind,  it  becomes 
necessary  to  refine  upon  some  of  the  commonly  ac- 
cepted ideas  of  the  nature  of  bank  credit  and  particu- 
larly of  its  relation  to  money.  It  is  seen  at  once  that 
the  "credit"  furnished  by  banks  is  an  independent 
medium  of  exchange,  and  that  while  the  bank  has  an 
important  and  significant  duty  to  perform  in  convert- 
ing claims  upon  it  into  money  when  demanded,  this 
is  only  an  incident  of  its  general  work.  The  money- 
furnishing  or  money-transferring  business  of  a  bank 
is  not  its  most  important  side,  and  as  the  bank  in- 
creases in  the  scope  of  its  operation  the  proportion  of 
its  transactions  which  consists  in  the  furnishing  of 
money  tends  to  decrease.  When  reserve  banking  is 
introduced  the  relation  of  the  bank  to  money  becomes 
still  more  remote.  The  bank  then  no  longer  keeps 
reserves  in  money  for  the  purpose  of  paying  its  cus- 
tomers, but  it  transfers  this  function  to  the  central 
bank  and  devotes  itself  primarily  to  the  duty  of  passing 
upon  applications  from  its  clientele.  These  apphca- 
tions,  although  stated  in  terms  of  dollars,  and  although 
they  appear  as  requests  for  loans,  are  really  requests 
that  the  bank  should  credit  on  its  books  a  percentage 
of  the  assets  which  "borrowers"  can  command,  in 
order  that  the  latter  may  readily  use  these  values  in 
buying  and  selling  and  in  production.  This  gives  the 
bank  a  status  as  an  active  element  in  business,  which 
it  does  not  possess  as  long  as  it  is  thought  of  merely 
as  a  kind  of  pawnbroker  or,  at  best,  as  the  highest  type 
of  money  lender. 


CREDIT  AND   BANKING  21 

VII.  Functions  of  a  Bank. 

1 .  Recognition  of  Right  to  Credit. 

The  view  thus  given  of  bank  credit  in  general  fur- 
nishes the  key  to  the  view  which  should  be  taken  of  the 
bank  itself.  It  is,  as  we  have  already  seen,  a  credit 
institution — an  institution  for  the  in\'estigation,  dis- 
cussion, and  recording  of  credits.  It  is  not,  in  this 
aspect,  what  some  have  described  it,  an  enterprise 
for  "manufacturing"  credit.  The  "manufacture"  of 
credit,  as  clearly  appears  from  what  has  already  been 
said,  is  impossible.  A  basis  of  credit  is  automatically 
created  whenever  real  buying  power  or  value  is  in 
process  of  being  brought  into  existence.  Such  power  is 
created  during  the  expenditure  of  labor  and  capital, 
but  the  real  worth  or  value  is  often  intimately  asso- 
ciated with  the  other  elements  that  appear  in  the  gen- 
eral operations  of  his  concern.  The  basis  only  appears 
when  it  is  dissociated  from  the  other  elements  in  the 
aggregate  of  goods  and  expert  means  are  needed  to 
recognize  it.  The  first  function  of  a  bank,  then,  is  that 
of  recognizing  through  scientific  analysis  the  real  nature 
and  amount  of  the  values  which  are  presented.  Fun- 
damentally, therefore,  the  credit  department  of  a  bank 
is  the  basic  element  in  its  organization.  It  is  true  that 
in  the  past  many  banks  have  been  able  to  do  without 
credit  departments  and  that  at  the  present  time  there 
are  not  a  few  of  them — chiefly  the  smaller  and  less 
advanced  types  of  institution — which  ha\'e  no  credit 
departments,  or  only  very  rudimentary  organizations 
of  the  sort.  These,  however,  usually  accept  the  work 
of  credit  departments  operated  by  their  city  corre- 
spondents. The  true  work  of  a  bank  credit  dej)art- 
ment  is  done  whene\'er  any  loan  is  made.  It  may  be 
that  the  work  of  credit  analysis  is  incidentally  i)er- 
formed  by  the  president  or  a  vice-president  of   the 


22  BANKING  AND  BUSINESS 

bank  or  by  some  other  officer  who  happens  to  have 
charge  of  the  work  of  lending,  but  the  function  is  there. 

2.  Guaranteeing  of  Values. 

Secondly,  the  bank,  after  recognizing  or  analyzing 
credit,  guarantees  it.  It  does  this  by  substituting  its 
own  credit  for  that  of  the  "borrower"  or  owner  of 
wealth.  If  A,  for  example,  is  producing  steel  from  pig 
iron,  the  bank  ascertains  the  value  of  the  products 
which  he  has  in  process,  which,  we  may  say,  is  $25  per 
ton.  It  undertakes  to  loan,  say,  $10  per  ton,  and  in 
order  to  carry  out  its  part  of  the  agreement  it  obligates 
itself  to  pay  $10  on  demand  to  anyone  who  may  be 
designated  by  the  owner  of  the  plant.  The  owner  leaves 
with  the  bank  his  own  note,  which  may  be  secured  or 
may  be  simply  a  claim  upon  his  general  assets.  In  either 
case,  however,  the  loan  is  made  on  the  strength  of 
existing  value.  It  represents  that  part  of  the  value  of 
the  product  which  the  bank  is  willing  to  guarantee. 
The  bank  does  not  expect  to  be  called  upon  to  meet 
this  obligation  for  $10  per  ton.  On  the  contrary,  it 
expects  to  offset  the  obligation  against  other  claims, 
and  as  a  net  result  it  believes  that  it  will  not  be  called 
upon  to  reduce  its  holding  of  specie.  That,  however, 
is  to  be  determined  at  a  later  time.  The  bargain  which 
the  bank  makes  when  it  enters  into  relationships  with 
the  borrower  involves  the  substitution  of  its  own  obli- 
gation for  that  of  the  owner  of  the  goods,  and  this  is 
the  essential  point  in  the  whole  operation. 

5.  Transferring  of  Titles. 

Thirdly,  the  bank  not  only  undertakes  to  put  its 
obligation  in  place  of  that  of  the  borrower,  but  it  un- 
dertakes to  keep  this  obligation  steadily  redeemable  on 
demand  in  money,  or  in  lieu  of  such  redemption,  to 
shift  the  "credit"  from  A  to  B  and  from  B  to  any 


CREDIT  AND   BANKING  23 

other  that  the  latter  may  indicate,  through  a  process 
of  bookkeeping  which  involves  the  receiving,  recording, 
and  paying  of  claims  drawn  against  the  total  credit 
which  has  been  allowed.  Closely  connected  with  this 
function  are  the  subordinate  duties  of  exchange  and 
remittance,  which,  as  will  be  seen  at  a  later  point,  arc 
variants  of  the  same  general  function. 

VIII.  Banking  as  a  Form  of  Credit  Mechanism. 

It  thus  appears  that,  in  its  pure  form,  banking  is 
essentially  a  study  of  credit,  a  process  of  insuring  such 
credit,  and  the  transfer  of  titles  thereto.  It  is  partly  a 
process  of  scientific  analysis  and  partly  a  business 
organized  for  poohng  or  distributing  risks.  Most  of 
the  risks  incurred  turn  out  favorably  to  the  banker. 
Some  do  not,  and  the  loss  which  results  from  this 
minority  of  risks  is  borne  by  the  banker  out  of  his 
profits  on  the  other  operations  he  has  undertaken,  or 
at  times  out  of  his  capital.  In  one  sense,  therefore, 
banking  is  credit  insurance,  and  in  another  sense  it  is 
credit  recording  and  credit  transfer.  Its  relations  to 
money,  the  holding  of  funds,  the  payment  of  checks, 
dealings  in  specie,  the  issue  of  notes  to  take  the  place 
of  coin,  and  many  others  are  merely  incidents.  They 
have  developed  as  the  outgrowth  of  the  banking  business. 
Many  of  them  are  necessary  to  the  convenience  of  the 
public ;  others  may  be  better  performed  by  some  other 
types  of  institution  and  will  eventually  be  transferred 
to  such  institutions.  The  essential  function  of  bank- 
ing remains  and  is  basically  necessary  in  any  society 
which  is  developed  upon  a  footing  of  di\ision  of  labor 
and  exchange  of  values.  In  such  a  societj'  credit 
must  be  had  by  those  who  produce  goods  that  are  not 
immediately  consumable  or  instantly  salable.  The 
bank  makes  this  credit  available.     Banking  is  therefore 


24  BANKING  AND   BUSINESS 

a  part  of  the  credit  mechanism  of  society,  and,  since 
the  latter  is  essential  to  any  advanced  development  of 
business  or  industrial  life,  banking  is  also  essential 
thereto.  Banking,  however,  does  not  develop  business 
or  ordinarily  precede  the  division  of  labor,  but  succeeds 
it.  It  is  not  a  profession  or  occupation  which  initiates, 
but  one  which  follows.  In  this  aspect  it  may  be  classed 
in  some  measure  with  railroad  transportation.  True, 
a  railroad  may  be  built  through  an  uninhabited  country 
and  its  owners  may  then  await  the  slow  development 
of  freight.  In  the  same  way  the  bank  may  be  built 
up  in  advance  of  the  business  enterprise  which  will  give 
it  full  occupation.  These,  however,  are  pioneer  ac- 
tivities which  must  be  regarded  as  the  exception  and 
not  the  rule. 

What  has  been  said  thus  far  is,  as  has  been  made 
clear,  applicable  solely  to  what  is  called  conamercial 
bank  credit — ^the  extension  of  credit  or  the  making  of 
loans  by  the  creation  of  deposits  and  the  issue  of  notes. 
This  is  a  typical  method  of  bank  operation  in  so  far 
as  relates  to  what,  for  want  of  a  better  term,  we  call 
commercial  credit — the  credit  which  involves  the 
exchange  of  goods  or  the  application  of  funds  to  the 
process  of  making  them  ready  for  consumption  over 
very  short-term  periods. 

IX.  Investment  Banking. 

It  has  been  pointed  out,  as  a  reason  why  the  theory 
of  credit  cannot  be  regarded  as  final  or  absolute, 
that  this  ''short-term  credit"  is  not  capable  of  exact 
definition  and  that  what  is  short  term  in  some  countries 
may  be  long  term  in  others,  and  vice  versa.  It  has 
also  been  noted  that  the  time  element  as  a  test  of  the 
character  of  credit  is  unsatisfactory,  and  that  the  better 
way  of  discriminating  between  types  of  credit  is  that 


CREDIT  AND   BANKING  25 

of  relating  them  not  to  time  as  a  standard,  but  to  the 
use  that  is  made  of  the  proceeds.  Looking  at  the  sub- 
ject from  that  standpoint,  another  branch  of  the 
analysis  of  credit  must  be  devoted  to  what  is  termed 
investment  or  long-term  credit,  by  which,  as  already 
seen,  is  meant  the  conversion  of  consumption  goods  or 
circulatory  funds  into  capital  goods — that  is  to  say, 
the  establishment  of  income-producing  properties. 
The  essential  distinction  between  this  type  of  credit 
and  the  kind  of  banking  wliich  provides  it  (ordinarily 
known  as  "investment  banking")  may  be  made  evident 
by  a  simple  illustration.  A  is  a  farmer  who  wishes 
to  drain  his  land  and  fence  it.  He  applies  to  a  trust 
company  or  investment  institution  for  a  loan  to 
enable  him  to  perform  the  work.  This  institution  has 
received  from  a  number  of  persons — X,  Y,  and  Z — 
funds  which  have  grown  out  of  their  sa\ings.  X, 
Y,  and  Z,  w^e  may  suppose,  are  salaried  men  each  of 
whom  had  at  the  end  of  the  year  found  himself  pos- 
sessed of,  say,  $1,000.  Each  has  deposited  this  sum 
in  the  trust  company.  This  means  that  the  trust 
company  has  given  them  a  claim  upon  it  which  may 
be  exercised  in  the  purchase  of  actually  existing  goods. 
X,  Y,  and  Z,  for  instance,  might  take  their  funds  and 
with  them  buy  clothing,  automobiles,  or  consumable 
goods  of  any  kind.  They  have  not  done  so,  but 
instead  they  wish  to  transfer  this  consuming  power  to 
some  one  else  who  will  pay  them  a  return  on  their 
ownership.  The  trust  company  decides  to  lend  the 
$3,000  to  Farmer  A,  and  does  so,  charging  remunera- 
tion for  its  service  in  investigating  and  making  the  loan. 
X,  Y,  and  Z  have  now  become  creditors  of  the  farmer 
upon,  let  us  say,  a  five-year  mortgage.  The  farmer 
with  his  $3,000  in  hand  uses  the  funds  in  employing 
labor — that  is  to  say,  he  gives  the  "money"  to  labor- 
ers,  who   use   it   in   supporting   themselves.     Viewed 


2G  BANKING  AND   BUSINESS 

from  another  standpoint  this  merely  means  that  the 
laborers  have  received  the  money  and  have  used  it  in 
buying  clothing,  food,  etc.,  so  that  they,  and  not 
X,  Y,  and  Z,  have  enjoyed  and  used  up  these  con- 
sumable goods.  Their  labor  has  resulted  in  improving 
the  farm,  and  as  a  result  the  farmer  is  able  to  produce 
a  larger  crop  yield.  A  part  of  this  crop  yield  he  pays 
to  X,  Y,  and  Z  as  "interest."  In  effect,  then,  the  long- 
term  credit  function  is  a  process  of  converting  imme- 
diate titles  to  goods  into  productive  machinery  or 
income-yielding  opportunities. 

X.  Commercial  and  Investment  Credit  Differen- 
tiated. 

A  difference  between  this  kind  of  credit  operation  on 
one  hand  and  commercial  credit  on  the  other  may  be 
found  in  the  fact  that  whereas  reimbursement  or  liqui- 
dation of  commercial  credit  comes  from  the  interchange 
of  existing  goods  or  goods  which  are  on  the  point  of 
being  rendered  consumable,  investment  credit  may 
eventually  be  liquidated  as  a  result  of  savings  made 
through  the  increase  of  productive  power.  Both  interest 
and  principal  will  be  repaid  to  those  who  have  advanced 
the  current  funds  only  as  a  result  of  a  real  increase 
in  wealth  resulting  from  the  productive  operation.  It 
is  evident  from  this  analysis  that  the  operations  which 
are  covered  by  the  term  investment  banking  rest 
upon  a  very  different  basis  from  that  which  is  usually 
included  under  the  term  commercial  credit.  The 
function  of  the  investment  bank  or  credit  institution 
is  that  of  accumulating  units  of  savings  or  current 
funds  whose  owners  are  wilhng  to  allow  them  to  be 
converted  into  investments — productive  or  income- 
yielding  opportunities.  The  difference  between  such 
credit  and  that  furnished  by  the  commercial  bank  is 


CREDIT  AND  BANKING  27 

ordinarily  spoken  of  as  being  one  of  time,  but,  as  has 
already  been  frequently  indicated,  the  essential  dif- 
ference is  not  that  of  time,  but  rather  of  the  use  that 
is  made  of  time.  It  is  a  difference  in  the  character  of 
the  enterprise  that  is  undertaken.  The  characteristic 
enterprise  undertaken  with  the  use  of  commercial 
credit  is  that  of  bringing  together  consumers  and  pro- 
ducers, while  the  characteristic  enterprise  undertaken 
by  the  investment  institution  is  that  of  bringing  to- 
gether producers  and  those  who  desire  income  rather 
than  immediate  enjoyment  of  capital.  This  is  a  dif- 
ference which,  as  will  be  seen,  involves  broad  and 
fundamental  differences  of  method  m  banking  and 
far-reaching  differences  in  canons  of  judgment  as  to 
banking  soundness  or  liquidity. 


CHAPTER  III 

CREDIT   INSTRUMENTS 

Credit  in  the  sense  in  which  it  has  already  been 
defined  as  a  means  of  exchanging  goods  has  to  take  some 
definite  form.  Although  credit  itself  is  intangible, 
in  actual  practice  it  assumes  a  distinct  shape.  The 
form  in  which  credit  is  represented  in  ordinary  business 
Ufe,  or  from  another  point  of  view,  the  forms  of  credit, 
or  still  in  other  words,  tangible  evidence  of  credit, 
are  what  are  known  as  credit  instruments.  Credit 
instruments  may  be  broadly  defined  as  evidence  of 
obligations  between  the  individuals  who  are  parties  to 
them.  They  present  a  variety  of  aspects,  and  since 
they  have  been  the  product  of  gradual  business  develop- 
ment, they  are  naturally  different  both  in  form  and  in 
legal  status. 

I.  Commercial  Credit  Instruments. 

1.  Open  Book-account. 

The  most  elementary  type  of  credit  instrument  may 
be  said  to  be  the  open  book-account.  A  sells  goods  to 
B  and  debits  him  with  the  value  of  these  goods,  or 
in  the  current  phrase  ' '  charges  "  them  to  him.  A  neces- 
sarily carries  some  kind  of  account  books  which,  in 
the  event  of  necessity,  can  be  produced  and  which 
contain  entries  to  show  the  amount  of  goods  he  has 
transferred  to  B.  Such  books  are  records,  having,  of 
course,  only  the  vahdity  which  they  acquire  from  the 
fact  that  they  are  entries  made  in  good  faith  at  the 


CREDIT   INSTRUMENTS  29 

time  of  the  transaction  to  wliicii  tiiey  refer.  Or- 
dinarily they  present  no  evidence  of  ha\'ing  been 
acknowledged  by  B.  Nevertheless,  they  are  in  a 
sense  a  credit  instrument — that  is  to  say,  they  are  a 
means  of  recording  or  measuring  credit,  or  of  furnishing 
evidence  that  it  has  been  extended.  The  idea  becomes 
more  fully  developed  when  we  conceive  of  both  A  and 
B  as  keeping  records,  each  perhaps  purchasing  from  the 
other,  and  their  records,  therefore,  agreeing  sub- 
stantially with  regard  to  the  amount  of  goods  given 
and  received.  If  at  the  end  of  a  fiscal  period  they 
exchange  receipted  statements,  these  are  evidently 
elementary  credit  instruments,  and  present  on  their 
face  evidence  that  the  transaction  indicated  by  the 
charges  to  account  has  been  completed  through  the 
transfer  of  an  equal  amount  of  goods,  or  through  some 
other  form  of  credit.  Such  receipted  statements  are 
a  derivative  of  the  books  of  record  of  the  concern, 
and  may  be  regarded  in  an  even  fuller  sense  than  the 
former  as  being  credit  instruments. 

2.  Promissory  Note. 

Another  step  in  the  direction  of  the  credit  instru- 
ment is  taken  when  the  recipient  or  buyer  of  the  goods 
gives  to  the  seller  an  acknowledgment  that  they  have 
been  received.  This  might  conceivably  be  nothing 
more  than  a  receipt  for  the  goods — a  signed  statement 
that  he  had  received  a  given  number  of  bushels  of 
wheat  or  yards  of  cloth  of  a  certain  kind.  Examples 
of  this  sort  are  seen  in  the  warehouse  receipt  which 
plays  so  important  and  growing  a  part  in  business 
to-day.  A  cotton  warehouse  receipt,  for  example,  is 
merely  the  acknowledgment  of  the  warehouse  operator 
that  he  has  received  from  his  customer  a  given  amount 
of  cotton  of  a  specified  grade  and  is  holding  it  for  him. 
A  still  further  step  is  taken  when  the  receipt  specifies 


30  BANKING   AND   BUSINESS 

the  value  of  the  goods — B,  for  example,  certifying  to 
the  receipt  of  a  given  number  of  bushels  of  wheat  at 
$1  per  bushel.  Since  in  this  instance  B  has  acknowl- 
edged receiving  goods  of  a  specified  value,  it  is  inferred 
that  he  has  obligated  himself  to  settle  for  or  liquidate 
the  obligation  in  an  equal  amount.  A  final  step  may 
be  taken  when  B  does  not  specify  the  kind  or  character 
of  the  goods  received,  but  merely  acknowledges  him- 
self to  be  indebted  in  a  specified  amount  for  "value 
received."  In  this  case  a  full-fledged  ''credit  instru- 
ment" has  been  worked  out.  It  is  what  is  ordinarily 
termed  a  note,  and  constitutes  a  legal  obligation  on  the 
part  of  B  to  pay  A  a  given  number  of  dollars — that  is  to 
say,  to  return  to  B  value  w^hich  is  represented  by  a 
given  sum  in  dollars,  although  A  may,  if  he  choose, 
exact  an  actual  settlement  in  money. 

S.  Bill  of  Exchange. 

Exactly  the  same  result  might  be  reached  by  a  some- 
what different  route,  giving  rise  to  a  rather  different 
t^-pe  of  credit  instrument.  If  A,  when  he  sent  the 
goods  to  B,  had  drawn  upon  the  latter  by  issuing  an 
order  to  him  to  pay  a  specified  sum  either  to  A  himself 
or  to  some  one  else  at  a  given  date,  this  order  would 
have  been  called  a  "draft"  or  bill  of  exchange. 

Bills  of  exchange  may  be  classified  according  to  the 
party  on  whom  drawn  or  the  time  \vhen  payable.  If 
drawn  on  a  person,  firm,  or  corporation,  they  are  called 
trade  bills,  and  if  on  a  banking  institution,  they  are 
described  as  bankers'  bills.  They  are  termed  sight 
drafts  if  payment  can  be  demanded  on  presentation, 
or  at  a  fixed  time  after  sight,  and  time  bills  if  they 
mature  on  a  specified  future  date.  The  term  "accept- 
ance" may  have  several  meanings  and  therefore  re- 
quires explanation.  In  the  first  place  it  may  refer 
to  the  act  of  the  drawee  in  writing  across  the  face  of 


/  Icryg  ~°^'  ■ 


9Ular. 


PROMISSORY     NOTE 


N^VTIONAL  B.VNK  OF  COMMERCli    1-23 


IN'  XEM'YORIi 


Pai-tothe  ^      /  ^ 

ORDER  OF --»'»-ft^.      'J-^t^z^g^ 


-$ii2i 


(s; 


- /kH-51-f<^ife«i_ 


-Dollars 


BANK   CHECK 


-CUtU- 


■(^  /aca  "'CO 


t/^y^f/t^^  k. 


-/i^i'irl' 


BANK    ACCEPTANCE 

TYPICAL  CREDIT  LNSTRUMENTS 


32  BANKING  AND   BUSINESS 

the  instrument  a  formal  acknowler^gment  of  the  order 
addressed  to  him  by  the  drawer  and  an  agreement  to 
pay  the  obligation  at  its  maturity.  The  term  accept- 
ance is  also  applied  to  a  time  bill  of  exchange  which 
has  thus  been  duly  accepted.  This  use  of  the  expres- 
sion ''acceptance"  is  found  in  commercial  practice, 
but  is  not  recognized  in  law. 

In  a  more  restricted  sense,  acceptance  is  the  expres- 
sion inscribed  on  the  bill  by  the  acceptor.  It  may  be 
written  simply  as  follows: 

Accepted 
July  1,  1921. 
William  Smith. 

This  form  is  described  as  unqualified  acceptance,  for 
the  drawee  agrees  to  make  payment  at  the  time,  to 
the  parties,  at  the  place  and  in  the  amount  specified 
on  the  face  of  the  bill.  The  acceptance  wTitten  by 
the  drawee  is  said  to  be  ''qualified"  when  it  differs 
in  any  way  from  the  order  addressed  by  the  drawer. 
The  above  acceptance  may  be  qualified  in  any  one 
or  more  of  the  following  ways: 

(1)  Time.  The  bill  reads  "payable  thirty  days 
after  sight,"  but  the  acceptor  extends  the  time  to  sixty 
days  after  sight. 

(2)  Parties.  The  draft  is  drawn  on  Jones  and  Smith, 
but  Smith  alone  accepts. 

(3)  Place.  A  draft  is  payable  at  the  acceptor's 
business  office,  but  the  place  of  paj^'ment  is  restricted 
by  an  acceptance,  reading,  "Payable  at  the  X  Bank 
only." 

(4)  Amount.  The  bill  is  drawn  for  SI, 000,  but  the 
drawee  acknowledges  only  S800  and  not  the  full 
amount. 


CREDIT   INSTRUMENTS  33 

4.  The  Check, 

The  credit  instruments  which  we  have  spoken  of 
thus  far  ha\'e  been,  as  ah'eady  seen,  evidence  of  obliga- 
tions growing  out  of  the  transfer  of  goods  between 
individuals  and  gi\'ing  rise  to  obligations  stated  either 
in  terms  of  goods  or  in  terms  of  money.  There  is  no 
reason,  however,  why  the  transaction  should  not  be 
an  operation  in  money  througliout.  For  example,  if 
A  advances  to  B  a  title  to  money  or  money  itself,  he 
may  simply  charge  B  with  the  amount  on  his  books, 
or  if  B  ''deposits"  money  with  A,  the  latter  may 
simply  credit  the  former  with  the  amount.  When  a 
bank  does  this  it  enters  the  amount  thus  deposited  in 
a  deposit  book  or  bank  book  which  is  presumably  a 
duplicate  of  B's  account  as  carried  on  the  books  of  A 
(in  this  case  the  bank),  and  which  thus  acts  as  a  kind 
of  receipt  or  voucher,  or,  as  we  have  learned  to  call  it, 
a  credit  instrument.  Suppose  now  that  B,  desiring  to 
withdraw  some  of  these  funds  from  the  custody  of  A, 
directs  A  to  pay  them  out  in  cash  either  to  himself  or 
some  one  else,  or  to  transfer  them  on  his  books  to  the 
credit  of  some  one  else,  a  written  instrument  will  be 
needed  for  this  purpose,  which  is  nothing  more  than  an 
order  to  A  to  pay  or  transfer  the  credit  obtained  by  B. 
This  is  called  a  draft  or  check.  When  the  transaction 
in  question  occurs  between  an  individual  (B)  and  the 
bank  (A)  the  term  "check"  is  universally"  employed, 
and  the  check  is  in  the  fullest  sense  of  the  term  a  credit 
instrument. 

II.  Legal  Aspects. 

In  commercial  usage  the  term  bill,  or  bill  of  exchange, 
is  practicall}"  synonymous  with  the  draft  or  accepted 
draft.  AMicre  the  words  notes,  drafts,  and  bills  of  ex- 
change   are    used,    the    term    "notes"    covers   direct 


34  BANKING  AND   BUSINESS 

obligations  between  j)ersons  of  the  kind  already 
referred  to;  the  term  "drafts"  usually  means  orders 
drawn  upon  a  bank  or  by  one  bank  upon  another, 
while  the  term  "bills,"  or  bills  of  exchange,  is  used  to 
include  drafts,  whether  accepted  or  unaccepted,  grow- 
ing out  of  transactions  in  goods. 

Lawyers  usually  apply  to  the  economic  class  of  credit 
instruments  the  term  "negotiable  paper."  Negotiable 
paper  is  not  exactly  identical  with  credit  instruments, 
the  concept  of  the  lawyer  being  rather  different  from 
that  of  the  economist  or  of  the  individual  business 
man.  Works  on  legal  relationships  and  commercial 
paper  usually  state  that  there  are  to  be  included  under 
the  term  "negotiable  instruments,"  or  "negotiable 
paper,"  checks,  drafts,  and  bills,  the  last  named  being 
either  accepted  or  unaccepted.  Negotiability  is  de- 
fined by  lawyers  as  the  power  to  transfer  title  abso- 
lutely and  without  the  necessity  of  notice  incurring 
liability  on  the  part  of  the  recipient.  For  example,  if 
A  gives  B  a  check,  B  may  indorse  the  check  and 
transfer  it  to  C  ,who  may  then  cash  it  without  paying 
any  attention  to  the  question  whether  B  had  come  by 
the  instrument  lawfully  or  whether  he  was  indebted 
to  others  who  may  have  been  conceived  to  have  a 
prior  claim  or  not. 

The  parties  to  negotiable  paper  are  said  to  be  the 
maker  or  drawer,  the  drawee,  and  the  various  indorsers. 
Thus  if  A  borrow^s  $500  from  B  and  gives  B  a  note  for 
$500,  A  is  the  maker  of  the  note  which  evidences  the 
transaction.  If,  however,  B  draws  on  A  for  $500, 
B  is  the  maker  or  drawer  of  the  draft  and  A  is  the 
drawee.  If  B  then  accepts  the  draft  he  is  the  ac- 
ceptor. A  party  who  comes  into  possession  of  an 
instrument  before  its  maturity  through  legitimate 
means,  and  with  the  belief  in  its  legality,  is  known  as 
the  "bona-fide  holder"  or  "holder  in  due  course." 


CREDIT   INSTRUMENTS  35 

1.  Conditions  of  Negotiability. 

Since  credit  instruments  are  the  means  of  making 
payments,  they  must  possess  certain  characteristics 
which  enable  them  to  pass  freely  from  hand  to  hand. 
In  the  United  States,  those  features  are  summarized 
in  the  Negotiable  Instruments  Law  as  requiring  that  a 
credit  instrument 

"1.  Must  be  in  writing  and  signed  by  the  maker  or 
drawer ; 

2.  Must  contain  an  unconditional  promise  or  order 

to  pay  a  certain  sum  in  money; 

3.  Must  be  payable  on  demand  or  at  a  fixed  or 

determinable  future  time; 

4.  Must  be  payable  to  the  order  of  a  specified 

person  or  to  bearer:  and, 

5.  Where  the  instrument  is  addressed  to  a  drawee, 

he   must   be   named   or   otherwise   indicated 
therein  with  reasonable  certainty." 

Thus  the  essential  conditions  of  negotiability  relate 
to  the  general  nature,  parties,  and  payment  of  the 
instrument. 

Although  a  credit  instrument  is  in  the  nature  of  a 
contract,  it  must  always  be  in  written  form.  An  oral 
obhgation  to  pay  money  would  not  be  a  tangible  e\-i- 
dence  of  the  debt  and  so  could  not  be  transferred  from 
one  party  to  another. 

Further,  the  instrument  must  be  specific  in  its 
reference  to  all  parties.  The  maker  must  afhx  his 
name  to  the  instrument,  otherwise  he  cannot  be  held 
liable  for  an  obligation  which  he  has  not  signed.  The 
signature  must  be  a  true  one,  since  the  holder  of  a 
forged  instrument  has  no  claim  against  a  party  whose 
name  has  been  thus  misused.  Although  the  instru- 
ment must  indicate  a  payee,  this  does  not  necessarily 


36  BANKING  AND  BUSINESS 

mean  that  the  name  of  the  individual  payee  shall  be 
specified.  An  instmment  reading,  "Pay  ten  dollars 
to  John  Smith,"  is  nonnegotiable  in  form,  while,  on 
the  other  hand,  "Pay  to  bearer"  is  negotiable,  since 
any  holder  for  value  may  claim  pajment.  The  instru- 
ment may  be  addressed  to  a  definite  payee  or  his  order 
as,  ''Pay  to  the  order  of  John  Smith."  Forms  which 
are  payable  to  bearer  or  to  order  are  negotiable,  for  they 
indicate  an  intention  on  the  part  of  the  maker  or  drawer 
to  become  generally  hable  not  only  to  the  person 
named,  but  to  unknown  persons  into  whose  hands  it 
may  pass,  while  in  the  case  of  an  instrument  not 
payable  to  order  or  bearer  the  maker  or  drawer  con- 
templates liabihty  only  to  the  payee  specified. 

A  negotiable  instrument  must  also  definitely  deter- 
mine the  manner  of  payment.  All  credit  instruments 
contain  either  an  order  to  pay,  as  in  the  case  of  check, 
or  a  promise,  as  in  the  note.  This  order  or  promise  to 
pay  must  be  absolute  and  in  no  way  conditional.  For 
example,  a  note  in  which  the  maker  agrees  to  pay  one 
hundred  dollars  "out  of  the  next  dividends  of  the 
United  Textile  Corporation"  would  be  nonnegotiable, 
for  its  payment  is  contingent  on  the  action  of  directors 
who  may  or  may  not  declare  dividends.  Because  a 
negotiable  instrument  performs  a  function  similar  to 
that  of  money,  the  promise  or  order  must  be  payable 
in  money  and  in  an  amount  that  is  certain.  An  order 
to  pay  100  shares  of  United  States  Steel  would  not  be 
considered  a  negotiable  instrument.  Although  these 
securities  are  readily  sold  on  the  market  and  easily 
converted  into  cash,  still  they  possess  a  value  which  is 
continually  fluctuating,  and  so  is  not  certain  in  amount. 
Payment  must,  therefore,  be  made  in  legal- tender 
money,  which  means  United  States  currency.  If  so 
specified  in  the  instrument,  payment  may  be  effected 
in  another  currency,  such  as  the  German  mark,  even 


CREDIT   INSTRUMENTS  37 

though  the  value  of  this  unit  in  terms  of  the  dollar 
varies  from  day  to  day. 

There  must  be  no  uncertainty  as  to  the  time  of 
payment.  If  payable  at  sight,  the  obligation  becomes 
due  upon  presentation,  but  if  at  future  time,  this  date 
must  be  fully  determinable.  "Sixty  days  after  death," 
''on  or  before  July  1,  1921,"  are  both  determinable 
periods  of  time,  and  in  fact  "six  months  after  my 
death"  also  is  an  ascertainable  date,  for  it  follows 
after  an  event  which  is  inevitably  bound  to  happen. 
However,  a  promise  to  pay  money  "when  A  is  twenty- 
one  years  old"  is  nonnegotiable,  for  A  may  never  attain 
this  age. 

2.  Indorsement. 

The  correct  procedure  of  negotiating  an  instrument 
follows  certain  legal  principles  which  have  been  gradu- 
ally developed  by  commercial  usage.  An  instrument 
which  is  payable  to  bearer  may  be  negotiated  by  a 
holder  in  due  course  merely  by  transferring  it  to 
another  party,  and  this  act  is  known  as  delivery. 
But  if  the  document  is  payable  to  the  order  of  a  specified 
individual,  the  holder  must  indicate  the  surrender  of  his 
title  by  writing  his  signature  upon  the  reverse  side  of 
the  instrument.  This  act  is  known  as  indorsement. 
Therefore  negotiation  is  accomplished  either  by  simple 
delivery  or  by  delivery  and  indorsement.  The  payee 
who  performs  the  act  of  indorsement  is  called  the 
"indorser,"  and  the  party  to  whom  title  is  transferred 
is  known  as  the  "indorsee." 

Indorsement  may  serve  another  purpose  in  adding 
to  the  strength  of  an  obligation.  If  A  gives  B  a 
promissory  note,  it  may  be  further  strengthened  by 
having  C  add  his  indorsement.  Thus  C  gives  his 
conditional  promise  to  reimburse  B  in  the  event  of 
refusal  on  the  part  of  A. 

i  b .)  0 


38  BANKING  AND   BUSINESS 

The  various  forms  of  indorsement  may  be  classified 
in  respect  to  parties  mentioned  or  qualifications 
stipulated.  As  to  parties,  indorsements  may  be  either 
"special"  or  "blank."  A  special  indorsement  states 
the  name  of  the  indorsee,  as,  "Pay  to  the  order  of 
John  Smith,"  who  alone  can  further  transfer  the  in- 
strument. When  the  indorsee  is  not  designated,  the 
form  is  called  a  blank  indorsement.  The  instrument 
may  then  be  negotiated  by  any  holder  upon  mere 
deUvery,  for  no  further  indorsement  is  required.  This 
form  may  well  be  used  in  depositing  a  check  with  a 
bank.  The  depositor  who  signs  a  blank  indorsement 
thus  allows  his  bank  complete  freedom  in  securing  pay- 
ment of  the  check,  for  the  funds  are  payable  to  any 
holder. 

Classified  on  a  different  basis,  indorsements  are  either 
unqualified  or  qualified  and  restrictive.  The  illustra- 
tions given  above  are  both  unqualified,  since  they  con- 
tain no  statement  which  limits  the  free  negotiation  of 
the  instrument.  A  qualified  indorsement  transfers  the 
title  of  an  instrument,  but  at  the  same  time  exempts 
the  indorser  from  the  usual  liabiUties  which  result  from 
this  act.  To  accompUsh  this  purpose,  the  indorser 
writes  before  his  name  the  expression  "without  re- 
course," and  thus  serves  notice  on  any  holder  that  he 
cannot  enforce  his  usual  claims  against  the  indorser 
if  the  original  drawee  refuses  to  meet  his  obligation. 
An  instrument  may  be  qualified  in  another  way  by 
placing  upon  it  a  restrictive  indorsement,  such  as  the 
following:  "Pay  to  the  X  Bank  for  collection."  The 
indorser  thus  names  the  bank  as  indorsee  for  a  specific 
purpose,  which  in  this  case  is  to  secure  pajinent  of  the 
instrument.  The  consequence  of  this  form  of  indorse- 
ment is  to  end  the  negotiabihty  of  the  instrument,  for 
the  indorsee  is  prohibited  from  further  transferring  it. 


CREDIT   INSTRUMENTS  39 

3.  Presentment. 

Having  now  described  the  meaning  and  classification 
of  indorsement,  it  is  necessary  to  consider  next  the  effect 
of  this  act  on  the  various  parties  to  a  negotiable  in- 
strument. The  bona-fide  holder  has  the  right  to 
press  his  claim  for  full  pajment  against  the  other 
parties  to  the  instrument.  These  persons  are  not 
liable  in  the  same  degree,  and  may  be  divided  into  two 
classes.  The  first  group  includes  the  maker  of  a 
promissory  note  and  the  acceptor  of  a  bill  of  exchange, 
who  are  both  absolutely  liable  to  the  holder  for  pay- 
ment and  are  called  the  primary  obligors.  The  second 
group  includes  the  drawer  of  a  bill  and  the  indorser  of 
a  bill  or  of  a  note,  who  are  merely  under  a  conditional 
or  secondary  obhgation,  for  they  will  be  called  upon  to 
pay  only  if  the  maker  or  the  acceptor  has  refused  to 
meet  the  claim  of  the  holder. 

When  a  holder  of  an  instrument  brings  notice  of  the 
obligation  to  the  parties  primarily  liable,  this  act  is 
known  as  presentment.  A  demand  obligation  such  as 
a  check  is  presented  in  order  to  obtain  payment,  and 
a  bill  of  exchange  which  is  due  at  a  future  time  is 
presented  to  the  drawee  for  his  acceptance.  Pre- 
sentment is  merely  the  exhibiting  of  the  instrument, 
and  the  actual  request  for  payment  or  acceptance  is 
known  as  demand.  The  purpose  of  presentment  and 
demand  by  the  holder  is  to  secure  pajinent  from  the 
drawee  or  maker,  and  also  to  fix  the  liabilities  of  the 
parties  secondarily  obligated. 

Correct  procedure  must  be  observed,  otherwise  the 
holder  may  forfeit  claims  against  drawers  and  indorsers. 
Both  presentment  and  demand  must  be  made  at  the 
correct  time  and  place.  A  demand  obligation  should 
be  presented  within  a  reasonable  time  after  its  issue. 
In  the  case  of  a  check  this  may  be  interpreted  to  mean 


40  BANKING  AND  BUSINESS 

within  twenty-four  hours  if  the  holder  and  the  drawee 
bank  are  both  located  in  the  same  city.  But  if  the  holder 
delays  the  presentment,  and  if  in  the  meantime  the 
bank  fails,  the  claim  against  the  party  who  first  drew 
the  instrument  is  terminated.  Time  instruments  must 
be  presented  for  payment  on  the  day  specified.  If, 
however,  this  date  happens  to  fall  on  a  Sunday  or  legal 
holiday,  presentment  is  made  on  the  following  business 
day.  Presentment  for  both  demand  and  time  instru- 
ments should  be  made  within  business  hours,  which 
in  the  case  of  a  bank  would  mean  between  nine  o'clock 
in  the  morning  and  three  in  the  afternoon. 

The  place  of  payment  depends  upon  the  wording  of 
the  instrument.  If  the  place  of  payment  is  desig- 
nated as  at  the  X  Bank,  it  is  there  that  present- 
ment must  obviously  be  made.  If  no  address  is  given, 
it  is  understood  that  the  instrument  shall  be  presented 
at  the  obligor's  place  of  business  or,  if  it  cannot  be 
found,  at  his  residence. 

If  presentment  is  made  to  the  obligor,  and  he  accepts 
and  later  pays  the  instrument  when  due,  negotiation  is 
completed.  If  this  party  refuses  to  accept,  or  to  pay 
after  acceptance,  the  instrument  is  said  to  be  dishonored, 
either  for  nonacceptance  of  a  bill  or  for  nonpayment  of 
a  bill  or  of  a  note  which  is  due.  When  these  primary 
obligors,  whether  drawee  of  a  bill  or  the  maker  of  a  note, 
have  refused  to  meet  the  demand  of  the  holder,  he 
first  states  the  facts  of  the  presentment  and  dishonor 
in  a  formal  document  known  as  a  certificate  of  protest. 
He  then  turns  to  those  parties  who  are  secondarily 
liable  for  payment,  and  they  may  be  indorsers  or  the 
drawer  from  whom  the  holder  has  received  the  instru- 
ment. It  is  the  duty  of  the  holder  to  give  these  persons 
a  notice  of  dishonor.  In  this  document  he  informs 
them  that  the  instrument  in  question  has  been  legally 


CREDIT  INSTRUMENTS  41 

presented  at  the  proper  time  and  place,  but  as  accept- 
ance or  pajanent  has  been  refused  by  the  parties  who 
were  primarily  obligated,  the  holder  now  looks  for 
payment  from  the  parties  secondarily  liable.  If  the 
holder  of  a  dishonored  instrument  fails  to  notify  the 
drawer  or  the  indorser,  these  parties  are  thereby  dis- 
charged from  their  liabilities.  However,  the  indorser 
may  yield  his  right  to  presentment,  protest,  and  notice 
of  dishonor,  by  writing  before  his  signature  the  expres- 
sion ''Protest  waived." 

III.  Investment  Credit  Instruments. 

1.  The  Stock  Certificate. 

Consideration  has  thus  far  been  confined  to  notes 
and  bills,  which  are  the  fundamental  instruments  of 
commercial  credit,  but  attention  must  also  be  given  to 
investment  credit  instruments.  As  they  are  governed 
in  general  by  the  principles  of  negotiability  explained 
above,  it  is  necessary  to  analyze  only  the  special 
characteristics  of  each  class.  Investment  credit  in- 
struments are  issued  mainly  by  corporate  organizations, 
and  include  the  stock  certificate,  the  bond,  and  the 
short-term  note.  A  certificate  of  stock  represents  own- 
ership of  one  or  more  shares  or  parts  in  an  enterprise. 
If  a  corporation  is  organized  with  a  capital  stock  of 
$100,000  this  signifies  the  maximum  amount  which  may 
be  issued  under  its  charter.  In  order  to  effect  its  sale 
the  capital  stock  is  di^ided  into  a  number  of  shares. 
These  may  be  given  a  definite  face,  or  par  value,  as, 
for  example,  SI 00,  and  thus  the  above  corporation 
with  a  capitalization  of  $100,000  issues  1,000  shares. 
Shares  may  also  represent  merely  a  certain  proportion 
of  the  total  capital  stock,  and  since  these  are  without 
par  value,  the  money  worth  of  such  shares  is  determined 
by  whatever  price  they  will  bring  when  sold  on  the 


42  BANKING  AND   BUSINESS 

market.  These  shares  with  or  without  par  value  con- 
stitute the  common  stock  of  the  corporation. 

In  addition,  it  may  also  issue  preferred  shares,  con- 
stituting that  portion  of  the  capital  stock  which  pos- 
sesses certain  preferential  rights.  In  event  of  bank- 
ruptcy and  liquidation,  owners  of  the  preferred  stock 
may  have  a  prior  right  to  the  proceeds  of  the  assets 
before  the  holders  of  common  stock,  but  preferred  stock 
more  usually  has  reference  to  prior  claims  over  divi- 
dends of  the  corporation.  In  this  respect  preferred 
stock  may  be  classified  as  cumulative  or  noncumulative. 
The  former  gives  the  holder  considerable  assurance  of 
the  ultimate  payment  of  dividends,  for,  if  omitted 
within  a  given  time,  they  are  carried  over  into  the 
following  period,  and  these  arrears  must  first  be  paid 
before  the  owners  of  the  common  stock  receive  any 
dividends.  Noncumulative  preferred  stock  entitles 
the  holder  to  first  claim  over  profits  within  a  certain 
time,  but  if  earnings  prove  insufficient  and  there  is  a 
consequent  lapse  of  dividends,  holders  of  this  class  of 
preferred  stock  lose  their  claims,  for  the  obligations 
are  not  continued  into  the  next  dividend  period.  In 
general,  preferred  stock,  compared  with  common, 
possesses  such  advantages  as  greater  degree  of  security 
and  more  regularity  of  income,  but  on  the  other  hand 
it  entails  a  limitation  in  possible  profits,  for  its  yield 
is  usually  of  a  fixed  per  cent,  regardless  of  corporation 
earnings;  while  preferred  stock  is  either  cumulative  or 
noncumulative,  participating  or  nonparticipating  as  to 
dividends,  common  stock  is  always  uniform  in  nature. 

A  stock  certificate  is  not  exactly  a  credit  instrument. 
The  holder  is  not  a  creditor  of  the  corporation,  but  really 
a  part  owner,  and  therefore,  in  the  event  of  insolvency, 
possesses  no  claim  upon  assets,  but  in  fact  he  may  even 
under  circumstances  be  judged  liable  for  losses  in  pro- 
portion to  the  amount  of  his  stock  if  not  fully  paid. 


CREDIT   INSTRUMENTS  43 

In  a  way  the  stock  certificate  does  partake  of  the  nature 
of  a  credit  instrument,  for  it  is  transferable  through 
mere  blank  indorsement  on  the  reverse  side  by  the 
person  in  whose  name  it  is  issued. 

2.   The  Bond. 

A  bond  in  every  respect  is  an  instrument  of  credit. 
It  possesses  practically  all  the  features  of  a  time  note, 
for  it  is  a  promise  by  the  maker  to  pay  interest  and 
principal  at  a  designated  time  in  the  future.  It  is  a 
promise  written  in  a  formal  manner,  for  it  is  always 
under  seal.  As  the  bond  may  have  a  maturity  as  long 
as  one  hundred  years,  the  maker  is  usually  a  govern- 
ment or  a  corporation,  for  neither  an  individual  nor  a 
partnership  could  have  this  expectancy  of  life.  As  the 
amount  of  the  loan  may  aggregate  millions  of  dollars,  it 
is  obviously  impossible  to  borrow  the  entire  sum  from 
one  person,  and  so  it  is  divided  into  smaller  denomina- 
tions, usually  of  $1,000,  S500,  and  SlOO  for  each  bond. 
It  also  bears  a  fixed  rate  of  interest  which  is  generally 
payable  semiannually. 

The  bond,  the  same  as  any  other  promissory  note, 
may  be  either  secured  or  unsecured.  The  first  type  is 
secured  by  a  mortgage  in  which  the  corporation  conveys 
property  to  a  trustee,  who  may  take  steps  to  sell  it  for 
the  benefit  of  bondholders  if  the  interest  or  principal 
is  not  paid.  The  corporation  may  thus  pledge  property 
such  as  terminals,  factories,  or  stocks  and  bonds.  The 
unsecured  or,  as  it  is  usually  called,  the  debenture  bond, 
is  based  upon  no  tangible  assets,  but  rests  merely  upon 
the  general  credit  standing  of  the  corporation.  In  the 
event  of  default,  holders  of  such  bonds  cannot  foreclose 
on  any  special  assets  of  the  corporation,  for  their  only 
redress  is  to  bring  suit  as  creditors  on  notes  which  have 
been  unpaid,  and  so  dishonored. 

The  degree  of  negotiability  of  a  bond  depends  on 


44  BANKING  AND  BUSINESS 

whether  or  not  it  is  registered.  A  registered  bond  is 
payable  only  to  the  party  whose  name  is  designated  on 
the  instrument  and  recorded  on  the  booii:s  of  the  cor- 
poration. It  can  be  transferred  only  by  the  indorsement 
of  the  payee  and  by  the  recording  of  this  assignment  on 
the  ledgers  of  the  corporation  or  its  agents.  While 
the  registered  bond  is  thus  difficult  to  negotiate,  this 
very  feature  may  prove  advantageous  in  case  of  loss 
or  theft,  for  payment  could  then  be  made  only  by 
forging  the  owner's  name.  The  unregistered  bond  is 
more  readily  transferred,  since  it  is  payable  to  bearer 
and  is  therefore  negotiable  merely  by  delivery.  In- 
terest on  the  registered  bond  is  paid  directly  to  the 
party  specified,  while  in  the  case  of  the  um-egistered 
bond  this  disbursement  is  given  to  any  holder  of  the 
coupons  attached  to  the  instrument,  and  so  it  is  usu- 
ally called  a  coupon  bond.  Bonds  may  be  registered  as 
to  principal  and  also  as  to  interest.  The  coupon  itself 
may  be  regarded  as  a  promissory  note  in  which  the 
corporation  agrees  to  pay  the  holder  the  interest. 

3.  Short-term  Note. 

The  purpose  in  issuing  a  bond  is  to  raise  capital  for 
undertaking  more  or  less  permanent  improvements, 
and  this  accounts  for  the  length  of  its  maturity.  The 
corporation  may  secure  funds  to  cover  a  briefer  period 
of  time  by  means  of  the  short-term  note.  This  instru- 
ment is  similar  in  nature  to  a  bond,  for  both  documents 
are  promises  to  repay  borrowed  money.  They  differ 
in  the  matter  of  interest,  principal,  maturity,  and 
general  form.  The  short-term  note  is  generally  used  by 
a  corporation  in  a  period  when  stringency  renders  the 
money  market  unfavorable,  especially  for  long-term 
borrowers.  The  note  thus  bears  a  higher  rate  of  in- 
terest, and  because  of  this  expense  the  makers  seek  to 
limit  as  much  as  possible  both  the  amount  and  the 


CREDIT  INSTRUMENTS  45 

maturity  of  such  borrowings.  The  duration  of  a  short- 
term  note  seldom  exceeds  five,  and  usually  averages 
two,  years.  It  is  also  quite  informal  in  content  and 
no  seal  is  required. 

Bonds  and  stocks  differ  in  several  important  respects. 
The  bond  expires  after  a  definite  period  of  time,  while 
the  stock  has  in  fact  no  fixed  date  of  maturity.  Fur- 
thermore, the  interest  on  the  bond  must  be  paid  abso- 
lutely, while  dividends  on  the  stock  are  distributed 
only  if  justified  by  the  earnings  of  the  corporation. 
In  the  event  of  default  on  either  principal  or  interest, 
bondholders  may  press  their  claims  as  creditors,  while 
stockholders  possess  no  such  rights  since  they  are  part 
owners  in  the  enterprise. 


CHAPTER  IV 

THE   FIELD  OF  BANKING 

I.  Principles  of  Bank  Classification. 

The  thirty  thousand  banking  institutions  in  the 
United  States  may  be  classified  according  to  the  fol- 
lowing principles:  (1)  legal  status,  (2)  economic  func- 
tion, (3)  operating  method,  (4)  customers'  control, 
(5)  territorial  activity.  As  it  has  not  been  man- 
datory until  recent  years  for  bankers  to  secure  the 
authority  of  law  before  beginning  to  operate  their 
business,  there  are  still  many  private  or  unincorporated 
banks.  However,  the  vast  majority  are  chartered 
under  the  laws  of  the  various  states  or  the  national 
government.  So  in  a  general  way  banks  may  be 
grouped  as  either  private  or  public.  These  terms, 
of  course,  refer  only  to  the  subject  of  incorporation 
and  imply  no  difference  in  ownership,  for  American 
banks  are  universally  operated  by  private  capital. 
One  exception  is  the  Bank  of  North  Dakota,  which  is 
operated  by  state  funds  and  is  therefore  a  pubhcly 
owned  enterprise. 

Public  or  incorporated  banks  exist  by  virtue  of 
charters  either  passed  as  special  acts  of  a  legislative 
body  or  issued  under  the  general  incorporation  laws  of 
the  government.  In  the  United  States  the  granting 
of  special  charters  soon  gave  way  to  a  system  which 
permitted  any  group  of  individuals  to  enter  the  field 
of  banking  if  they  complied  ^^'ith  the  regulations  of  the 
general  incorporation  law.     Such  a  statute  was  enacted 


THE   FIELD   OF  BANKING  47 

first  in  New  York  and  was  later  copied  by  the  Western 
states.  Finally,  in  1863  Congress  provided  for  the 
federal  chartering  of  banks  under  a  general  law  known 
as  the  National  Bank  Act. 

A  second  classification  of  banks  rests  upon  the 
economic  function  which  they  perform.  One  class  of 
financial  institution  gathers  the  savings  of  the  com- 
munity and  provides  business  enterprises  with  per- 
manent capital  represented  by  stocks,  bonds,  or  notes. 
A  considerable  part  of  these  funds  will  be  applied  to 
erecting  factories,  extending  railways,  and  developing 
other  permanent  aids  to  production.  Investment 
banks  supply  industry  with  these  long-term  funds, 
while  on  the  other  hand  commercial  banks  to  a  large 
extent  furnish  short-term  credit,  enabhng  the  business 
man  to  purchase  materials,  pay  his  employees,  and 
meet  his  current  expenses. 

A  third  basis  for  classifying  banking  institutions 
rests  upon  their  method  of  operation.  One  group 
receives  deposits  and  through  them  obtains  the  funds 
which  it  employs  in  making  loans.  Other  banking 
institutions  accept  no  deposits,  but  finance  business 
undertakings  by  acting  solely  in  the  capacity  of  middle- 
men between  borrowers  and  lenders. 

A  fourth  basis  of  classification  is  based  upon 
the  control  of  the  bank.  It  is  usually  operated  i)re- 
cisely  as  an  ordinary  business  enterprise,  in  which 
customers  have  no  control  over  management.  AMiile 
the  depositor  may  at  times  be  a  stockholder  or  even  a 
director,  he  usually  exercises  no  influence  over  the 
policies  of  the  bank.  Certain  other  institutions,  how- 
ever, are  co-operative  in  nature  and  are  designed  to 
extend  loans  mainly  to  their  own  members. 

Banks  may  also  be  grouped  as  domestic  or  foreign, 
depending  upon  the  territory  in  which  they  conduct 
their  operations. 


48  BANKING  AND   BUSINESS 

These  five  methods  of  classification  are  by  no  means 
of  equal  significance.  The  legal  structm'e  of  a  bank 
exerts  small  influence  on  the  nature  of  its  business, 
for  it  matters  little  whether  or  not  it  is  incorporated. 
As  only  a  few  banks  are  co-operative  in  nature,  the 
question  of  customers'  control  requires  only  brief 
attention.  Also  there  is  no  essential  difTerence  in  the 
nature  of  a  bank  whether  engaged  in  financing  foreign 
or  domestic  business.  Thus  consideration  need  be 
given  only  to  the  economic  function  and  the  operative 
method  of  banking  institutions.  They  will  all  be 
briefly  viewed  in  this  chapter,  while  intensive  study 
will  later  be  given  to  the  more  important  types,  such 
as  commercial,  investment  and  savings  banks  and 
trust  companies. 

II.  Private  Banks. 

As  noted  above,  banking  may  be  conducted  by  either 
chartered  institutions  or  unincorporated  associations. 
The  latter  include  the  many  individuals  and  partner- 
ships conducting  private  banks.  In  the  country,  the 
individual  private  banker  is  often  a  business  man  who 
has  successfully  managed  a  local  enterprise.  Having 
thus  attained  the  confidence  of  the  community,  he  is 
in  a  position  to  receive  deposits  of  funds  and  make 
loans  to  his  neighbors. 

Private  bankers  are  also  found  in  cities  with  large 
colonies  of  immigrants.  These  persons  are  continu- 
ally remitting  funds  to  their  native  countries,  and 
occasionally  sending  steamship  tickets  to  bring  their 
friends  and  relatives  to  the  new  land.  The  low  rates 
quoted  on  European  currencies  have  tempted  many  to 
buy  foreign  exchange  solely  for  the  purpose  of  specula- 
tion.   Such    transactions    are    handled    bj^    private 


THE   FIELD   OF   BANKING  49 

individuals  who  frequently  operate  a  general  banking 
business. 

Another  type  of  private  bank  is  the  partnership, 
which  includes  a  powerful  group  of  financiers  engaged 
in  both  commercial  and  investment  banking  on  an 
international  scale.  One  well-known  firm  with  head- 
quarters in  New  York  has  through  connections  abroad 
extended  large  credits  for  the  financing  of  exports  and 
imports  for  over  a  century.  Another  is  an  unincor- 
porated association  of  a  large  number  of  partners  in- 
terested mainly  in  the  field  of  investment  banking. 
During  the  war  it  acted  as  fiscal  agent  for  foreign 
governments  and  floated  loans  of  unprecedented 
amount.  This  firm  also  organizes  syndicates  to  finance 
industrial  enterprises,  as  in  the  case  of  the  Great 
Northern-Northern  Pacific  railroads,  which  in  1921 
placed  on  the  market  securities  amounting  to 
$230,000,000. 

III.  Commercial    Banking    and    Financing    Insti- 
tutions. 

The  commercial  or  business  bank  performs  the 
operations  of  receiving  deposits  and  making  loans. 
It  uses  its  own  capital  and  its  receipts  of  money  as  a 
basis  for  the  making  of  loans  to  several  times  the 
amount  of  these  deposits.  A  bank  may  extend  a  loan 
to  a  customer  by  writing  the  amount  in  his  deposit 
account  against  which  he  can  then  draw  checks.  The 
borrower  may  also  receive  credit  from  the  bank  in  the 
form  of  its  notes,  which  circulate  throughout  the  com- 
niunity  as  media  of  exchange. 

Institutions  which  perform  these  operations  may  be 
grouped  according  to  whether  they  are  chartered 
under  state  or  national  law.     This  legal  distinction  no 


50  BANKING  AND   BUSINESS 

longer  affects  materially  the  scope  of  business  con- 
ducted by  either  type.  Until  recently,  while  state 
banks  were  generally  permitted  to  lend  money  on  farm 
land  and  other  real  estate,  national  banks  were  pro- 
hibited from  granting  such  loans.  On  the  other  hand, 
national  banks  have  been  allowed  to  issue  their  own 
notes  for  circulation,  but  similar  issues  by  state  institu- 
tions were  taxed  out  of  existence  by  a  federal  levy  of  10 
per  cent.  The  Federal  Reserve  Act  has  eliminated  these 
differences  between  commercial  banks  by  conferring 
upon  national  banks  the  right  to  lend  on  real  estate, 
but  at  the  same  time  providing  for  the  gradual  extinc- 
tion of  their  circulating  notes. 

Conamercial  banks  may  also  be  classified  according 
to  whether  their  business  is  essentially  domestic  or 
foreign.  Most  banks  are  engaged  in  financing  local 
transactions,  such  as  extending  credit  to  the  farmer 
for  raising  his  crops  or  to  the  manufacturer  for  operat- 
ing his  mill. 

In  addition  to  engaging  in  domestic  financing,  large 
commercial  banks,  particularly  in  the  seaboard  cities, 
also  operate  foreign  departments  for  extending  credit 
to  exporters  and  importers.  In  fact,  some  banks  do 
not  enter  into  the  financing  of  domestic  transactions  at 
all,  but  are  engaged  exclusively  in  facilitating  foreign 
trade.  These  institutions  perform  the  same  services 
as  the  domestic  bank,  but  differ  only  in  the  geographic 
area  of  their  operations.  While  these  institutions  con- 
fine their  activities  to  a  definite  territory,  nevertheless 
in  this  field  they  perform  all  the  operations  of  banking. 
They  receive  deposits,  make  loans,  and  at  times  issue 
notes  for  circulation. 

Although  city  banks  carry  the  accounts  of  firms 
representing  many  lines  of  business,  there  is  often  a 
tendency  to  specialize  the  extending  of  credit  to  certain 
industries.    This  is  due  in  a  large  measure  to  the  usual 


THE   FIELD   OF  BANKING  51 

concentration  of  firms  engaged  in  the  same  business  in 
one  locality,  and  obviously  banks  in  this  territory 
become  closely  identified  with  these  enterprises.  In 
the  financing  of  a  few  industries,  such  as  textiles  or 
automobiles,  specialization  has  advanced  to  a  stage 
where  an  institution  will  grant  credit  only  to  firms 
engaged  in  this  one  line  of  business. 

A  further  step  toward  specialization  has  been  the 
development  of  finance  corporations,  or  discount  com- 
panies, which  do  not  receive  deposits,  but  instead  act 
as  intermediaries  between  lenders  and  borrowers. 
This  type  of  banking  institution  discounts  or  buys  the 
accounts,  trade  acceptances  and  notes  receivable  of 
borrowing  firms,  and  on  the  basis  of  these  claims  sells 
its  own  obligations  to  individuals  and  banks,  who  thus 
become  the  real  lenders. 

Another  tj^De  of  specialized  intermediary  institution 
is  the  commercial-paper  house,  which  also  receives  no 
deposits,  but  extends  credit  to  borrowers  through  buy- 
ing their  obligations.  These  are  sold  directly  to  pur- 
chasers, and  in  this  respect  the  commercial-paper 
house  differs  from  the  discount  company  which  markets 
its  own  obligations.  In  no  case  does  the  dealer  indorse 
the  paper,  and  so  he  cannot  be  held  hable  by  the  pur- 
chaser if  the  instrument  is  dishonored  at  maturity. 
The  commercial-paper  house  also  differ^  from  the  dis- 
count company  in  that  it  is  not  incorporated,  but  is 
organized  as  a  partnership  or  headed  by  a  single 
individual. 

IV.  Investment  Banks. 

The  investment  banker,  like  the  commercial-paper 
dealer,  is  essentially  a  middleman  engaging  with  govern- 
ments and  corporations  who  seek  permanent  capital 
to  make  public  improvements  or  to  develop  private 


52  BANKING  AND   BUSINESS 

enterprises,  and  advising  individuals  and  institutions 
who  seek  to  invest  funds  for  a  long  period  of  time. 
The  investment  houses  are  usually  private  institutions 
conducted  by  a  small  group  of  partners.  Only  a  few 
are  incorporated  and  are  therefore  subject  to  practically 
no  pubhc  regulation.  Investment  houses  are  of  cer- 
tain recognized  general  kinds.  The  wholesale  banks 
purchase  large  issues  of  industrial  or  governmental 
securities  or  they  guarantee  the  raising  of  the  required 
sum.  These  firms  themselves  do  not  sell  to  investors, 
but  instead  leave  this  function  to  retailers.  The 
larger  houses  distribute  stocks  and  bonds  directly  to 
investors  and  also  indirectly  through  small  retailers  or 
bond  houses. 

In  the  field  of  investment  finance  there  are  certain 
institutions  which  parallel  the  discount  companies 
which  buy  claims  and  with  these  as  collateral  issue 
their  own  obUgations.  These  concerns  are  knowoi  as 
"investment  trusts."  In  England  and  the  Continent 
they  have  been  organized  for  years  for  the  purpose 
of  absorbing  foreign  securities,  and  on  these  as  a  basis 
selUng  their  own  debentures.  In  the  United  States 
this  plan  has  been  applied  largely  to  the  raising  of  loans 
on  city  and  country  property.  A  mortgage  of  several 
miUions  of  dollars  on  a  large  hotel  or  office  building  is 
distributed  by  the  investment  house  in  small  units 
among  a  large  number  of  investors.  The  holders  of 
these  bonds  become  creditors  of  the  issuing  bank,  but 
in  no  sense  are  they  the  mortgagees  of  the  property 
which  is  serving  as  collateral. 

Mortgagees  may  retain  title  of  property  pledged  and 
at  the  same  time  have  the  principal  and  interest  of  the 
mortgage  guaranteed  by  a  form  of  investment  bank 
which  specializes  in  this  service.  This  company  be- 
comes practically  the  indorser  of  the  obligation,  for  it 
assumes  all  liabilities  even  to  the  extent  of  fully  reim- 


THE   FIELD   OF   BANKING  53 

bursing  the  mortgagee  if  the  property  at  a  foreclosure 
sale  does  not  yield  an  amount  sufficient  to  cover  his 
claims. 


V.  Trust  Companies. 

Trust  companies  may  be  regarded  as  investment 
institutions,  for  they  also  contribute  permanent  capital 
to  industrial  and  railroad  corporations.  These  invest- 
ment activities  of  trust  companies  are  more  or  less 
ancillary  to  their  regular  fiduciary  business,  for  they 
are  called  upon  to  invest  large  sums  of  money  in  ad- 
ministering various  kinds  of  trusts.  A  trust  company 
may  act  in  behalf  of  another  corporation  or  of  a  person, 
and  so  it  handles  either  a  corporate  or  an  individual 
trust.  In  executing  corporate  trusts,  the  company 
may  act  in  such  capacities  as  manager  or  member  of  an 
underwriting  syndicate,  fiscal  agent,  trustee  under 
corporate  mortgage,  assignee,  and  receiver.  For  the 
individual,  the  trust  company  may  serve  as  executor 
under  a  will  or  administrator  under  court  order, 
guardian,  and  general  trustee.  These  classes  of  trusts 
are  described  in  full  in  Chapter  XV. 

VI.  Savings  Banks. 

The  savings  bank  is  also  a  form  of  investment  insti- 
tution. It  receives  deposits  mainly  from  persons  of 
moderate  means  who  are  desirous  of  selecting  a  secure 
depository  for  their  funds,  and,  since  they  seldom 
make  withdrawals  as  compared  with  commercial  de- 
positors, the  bank  is  able  to  place  these  savings  in  long- 
term  investments  such  as  real-estate  mortgages  and 
high-grade  securities.  Savings  banks  thus  perform 
a  distinct  service  by  indirectly  investing  the  surplus 
funds  of  persons  who  are  unable,  because  of  inexperi- 


54  BANKING  AND     BUSINESS 

ence,  directly  to  place  their  money  in  investments 
which  have  a  satisfactory  yield  and  procure  at  the 
same  time  maximum  safety. 

A  savings  bank  may  be  organized  either  as  a  stock  or 
nonstock  institution.  Funds  may  be  suppHed  from  the 
issue  of  capital  stock,  and  so  the  earnings  are  distributed 
in  the  form  of  dividends  to  shareholders.  They  elect 
a  board  of  directors,  who  control  the  operation  of  the 
bank.  While  this  stock  type  of  organization  is  found 
throughout  the  Western  and  Southern  states,  the  non- 
stock, or  mutual,  savings  bank  prevails  in  Northeastern 
states.  This  institution  has  no  capital  stock,  for  its 
resources  are  contributed  not  by  stockholders,  but 
emanate  from  the  organizers  and  later  from  depositors. 
In  place  of  a  board  of  directors  there  is  a  body  of 
trustees  who  determine  the  policies  of  the  mutual 
savings  bank  in  the  interest  solely  of  the  depositors. 

VII.  Co-operative  Banking  Institutions. 

Similar  to  the  mutual  savings  bank  is  the  build ing- 
and-loan  association.  They  both  receive  earnings  from 
a  number  of  small  depositors  and  lend  these  funds  on 
security  consisting  usually  of  real  estate.  These  asso- 
ciations are  owned  by  the  contributors  of  the  funds  and 
these  persons  receive  the  net  profits  derived  from  the 
granting  of  the  loans.  However,  there  is  a  difference 
in  operation.  The  savings  bank  obtained  its  resources 
from  persons  making  deposits,  while  the  loan  asso- 
ciation secures  its  funds  from  individuals  buying  shares 
in  the  organization.  Furthermore,  the  savings  bank 
uniformly  lends  its  money  to  borrowers  who  have  no 
connection  with  the  institution,  whereas  the  loan 
association  generally  grants  accommodation  only  to 
its  members.  Savings  banks  distribute  their  funds 
over  a  wide  range  of  investments,  but  loan  associations 


THE   FIELD   OF  BANKING  55 

ordinarily  confine  their  activities  to  assist  persons  who 
are  buying  real  estate  or  building  homes. 

Another  form  of  co-operative  banking  is  the  credit 
union.  Its  development  has  not  been  extensive  in  the 
United  States,  although  the  building-and-loan  associa- 
tion has  experienced  a  rapid  growth.  Both  aim  to 
encourage  thrift  among  their  members  by  receiving 
their  savings  and  lending  them  to  borrowers  at  a 
reasonable  rate  of  interest.  The  credit  union  differs 
from  the  loan  association  in  that  it  supplies  credit  for 
a  short  period  of  time,  and  makes  these  grants  exclu- 
sively to  its  own  members.  Thus  each  borrower  is 
personally  known  to  his  associates  in  the  union  and  so 
the  loan  is  based  on  his  character  rather  than  on  collat- 
eral such  as  real  estate. 

The  Morris  Plan  Bank  also  makes  loans  to  small 
borrowers  who  have  no  bank  accounts  and  who  find 
difficulty  in  securing  credit.  These  loans  are  made  on 
a  promissory  note  of  the  borrower,  whose  credit  is 
further  guaranteed  by  at  least  two  indorsers,  or 
''co-makers."  The  Morris  Plan  Bank  is  not  really  a 
co-operative  association,  for  while  it  seeks  to  sell  its 
shares  to  prospective  borrowers,  it  is  a  regular  business 
enterprise  whose  capital  is  derived  largely  from  stock- 
holders not  necessarily  recipients  of  loans. 

VIII.  Tendencies  in  American  Banking. 

From  this  survey,  it  must  not  be  concluded  that  the 
banking  structure  of  the  United  States  is  composed  of 
a  number  of  groups  of  specialized  institutions,  for  there 
has  been  comparatively  little  tendency  toward  speciali- 
zation in  the  field  of  banking  proper.  A  large  com- 
mercial bank  has  frcquentlj-  absorbed  a  trust  company, 
or,  on  the  contrary,  a  progressive  trust  company, 
desirous  of  entering  into  commercial  banking,  has  at 


5G  BANKING  AND  BUSINESS 

times  taken  over  a  long-established  national  loank.  These 
mergers  have  resulted  in  powerful  banking  institutions 
which  have  further  extended  their  activities  to  include 
other  fields  of  finance,  by  opening  departments  for 
receiving  time  deposits  and  also  by  operating  securities 
departments  for  handling  investments.  A  large  njod- 
ern  bank  is  therefore  able  to  offer  its  customers  prac- 
tically every  possible  financial  service  in  much  the  same 
manner  that  a  department  store  places  on  sale  goods 
of  every  description. 


Part    II 
COMMERCIAL  BANKING 


CHAPTER  V 

BANK  ORGANIZATION  AND  ADMINISTRATION 

I.  The  Bank  as  a  Type  of  Business  Organization. 

Having  surveyed  the  entire  field  of  banking,  con- 
sideration will  be  confined  to  the  various  aspects  of  the 
commercial  bank.  Its  organization  will  first  be  an- 
alyzed with  particular  reference  to  differences  and 
similarities  to  the  ordinary  business  enterprise.  The 
three  types  of  business  organization — -the  individual, 
partnership,  and  corporation — are  all  found  in  the 
field  of  banking.  Any  person  or  group  of  persons  may 
engage  in  banking  in  the  same  manner  as  in  an  ordinary 
private  business  such  as  retailing  or  manufacturing. 
Although  the  business  of  banking,  by  reasons  of  its 
semipublic  nature,  is  placed  under  certain  govern- 
mental regulations,  it  is  not  confined  by  law  to  the 
corporate  form  of  organization.  But  as  most  banks  are 
chartered  institutions,  it  is  necessary  to  study  them 
particularly  from  the  corporate  point  of  view. 

Chartered  banks  share  in  all  the  advantages  derived 
from  being  organized  as  corporations.  The  existence 
of  the  bank  is  practically  continuous,  for  it  receives 
a  charter  which  generally  allows  it  a  life  of  twenty 
years,  and  this  term  is  usually  extended  by  mere  appli- 
cation to  the  proper  authorities.  The  feature  of  the 
limited  habihty  of  owners  is  especially  attractive  in 
banking  where  the  element  of  risk  is  heavy.  Also  the 
issue  of  shares  renders  possible  the  raising  of  capital 
in  large  amounts. 


00  BANKING  AND  BUSINESS 

On  the  other  hand,  corporate  organization  carries 
with  it  certain  disadvantages  which  are  especially 
onerous  in  the  case  of  banks.  Heavy  taxes  must  be 
paid  to  the  federal,  state,  and  local  governments.  In 
addition,  both  national  and  state  supervisory  officials 
several  times  within  the  year  demand  detailed  reports 
concerning  the  financial  condition  of  the  banks,  and 
they  must  also  be  prepared  for  government  examiners 
who  may  visit  them  unexpectedly  and  conduct  search- 
ing investigations  of  all  operations. 

II.  The  Incorporation  of  a  Bank. 

Before  the  Civil  War,  when  banks  were  first  organ- 
ized as  corporations,  it  was  generally  necessary  to  obtain 
a  special  act  of  incorporation  from  the  legislature.  In 
time,  such  special  charters  gave  way  before  the  plan  of 
issuing  grants  under  a  general  incorporation  law  which 
viewed  the  bank  in  the  Ught  of  an  ordinary  business 
enterprise.  Later  a  distinction  was  drawn  between 
banks  and  other  corporations,  and  a  separate  banking 
law  was  enacted  for  granting  general  charters  to 
financial  institutions.  Since  the  National  Bank  Act 
has  served  as  a  model  for  similar  statutes  in  the  various 
states,  only  the  steps  required  for  federal  incorporation 
will  be  described. 

Banks  are  organized  for  a  wide  variety  of  reasons. 
A  new  connnunity,  undergoing  rapid  industrial  ex- 
pansion, may  urgently  need  banking  facihties  larger 
than  the  existing  institutions  are  able  to  provide.  If 
the  older  banks  are  already  discounting  all  the  com- 
mercial paper  which  their  resources  permit,  if  their 
loans  are  approaching  the  hmit  fixed  by  law,  and  if 
this  strain  is  not  met  by  increasing  capital  stock,  then 
it  is  time  for  the  pubUc  to  insist  upon  a  new  organiza- 
tion.    However,  not  all  banks  are  founded  because  of 


BANK  ORGANIZATION  61 

legitimate  economic  needs.  It  may  happen  that  a 
minority  group  of  directors  or  stockholders  becomes 
dissatisfied  with  the  lending  pohcy  of  the  established 
bank  and  seeks  better  results  in  a  new  enterprise. 
Fortunately  for  the  business  of  banking,  it  has  not  been 
seriously  invaded  by  the  professional  promoter  who 
has  launched  so  many  unsuccessful  ventures  in  other 
fields  of  corporate  organization.  In  a  large  measure 
this  is  due  to  the  careful  regulations  \^■ith  which  the 
law  has  safeguarded  the  starting  of  a  new  bank. 

In  organizing  a  national  bank  a  prescribed  routine 
must  be  closely  followed.  First,  an  application  is  made 
by  five  or  more  natural  persons  to  the  Comptroller  of 
the  Currency  at  Washington.  This  appHcation  must 
be  indorsed  by  three  public  officials  of  the  district 
where  the  prospective  bank  is  to  be  situated.  The 
object  of  this  regulation  is  to  give  some  assurance 
that  the  new  bank  is  the  result  of  an  actual  local 
demand,  and  not  the  product  of  external  influences. 
After  the  application  has  been  received,  an  examiner  is 
sent  to  survey  the  economic  and  financial  condition 
of  the  community.  He  studies  local  industries  and 
their  prospects  for  development  to  determine  whether 
their  future  needs  fully  justify  the  establishing  of  an- 
other bank.  The  examiner  analyzes  the  operation  of 
the  older  institutions  to  judge  whether  their  interest 
rates  are  reasonable  or  general  services  satisfactory. 
He  also  considers  whether  the  organizers  possess  general 
character  and  financial  experience  necessary  to  inspire 
the  confidence  of  prospective  stockholders  and  de- 
positors. If  the  findings  of  the  examiner  are  favorable 
and  if  the  Comptroller  has  approved  the  application, 
the  next  step  in  forming  the  new  bank  is  to  circulate  a 
subscription  list.  It  is  signed  by  prospective  share- 
holders, who  are  required  to  declare  the  amount  of 
their  subscriptions.    The  contract  serves  as  an  indica- 


62  BANKING  AND   BUSINESS 

tion  of  the  support  which  the  community  is  hkely  to 
give  to  the  new  bank,  and  also  acts  as  an  engagement 
which  binds  subscribers  to  their  pledges.  The  sub- 
scription list  is  no  longer  considered  as  a  necessary 
instrument  in  many  states  in  the  forming  of  industrial 
corporations,  but  it  is  still  required  by  law  in  the 
incorporating  of  banks.  Five  or  more  persons  sign  the 
"articles  of  association"  and  the  "organization  cer- 
tificate" containing  such  details  as  name  of  the  bank, 
location,  amount  of  stock,  and  number  of  directors. 
The  certificate  of  organization  may  be  regarded  vir- 
tually as  a  charter,  since  it  signifies  that  the  incor- 
porators have  complied  with  the  national  law  and  that 
they  are  now  authorized  to  open  the  doors  of  the  new 
bank  for  business. 

III.  Capital  Stock. 

It  is  evident  that  organizing  a  national  bank  in 
some  respects  differs  from  starting  an  ordinary  business 
corporation.  The  bank's  capital  stock  has  particular 
characteristics  not  ordinarily  possessed  by  other  cor- 
porations. The  business  incorporation  laws  of  the 
states  usually  leave  the  amount  of  stock  authorized  in 
the  charter  to  the  judgment  of  the  organizers.  In 
banking  it  is  highly  desirable  to  determine  a  minimum 
limit,  so  that  new  banks  shall  begin  with  funds  adequate 
to  meet  initial  expenses.  This  minimum  could  be  made 
uniform  for  all  banks,  but  it  is  a  better  plan  to  adjust 
the  amount  according  to  the  volume  of  business  which 
may  be  anticipated.  The  sum  cannot  be  predicted 
with  any  degree  of  accuracy,  and  therefore  the  mini- 
mum capital  required  by  law  is  graded  according  to  the 
population  of  the  city  in  which  the  bank  has  its  sit«. 
On  the  theory  that  there  is  a  relation  l)etween  the 
volume  of  business  and  the  size  of  the  locahty  the  re- 


BANK  ORGANIZATION  63 

quirements    under    the    National    Bank    Act    are    as 
follows : 

Minimum  Capital  Population  Less  Tham 

$  25,000 3,000 

50,000 6,000 

100,000 50,000 

Over  200,000 Over  50,000 

These  regulations  were  enacted  in  1900  and  have 
remained  unchanged,  although  the  general  price  level 
has  practically  doubled  within  this  period.  The  above 
requirements,  therefore,  are  inadequate  to  meet  the 
existing  needs  of  business,  but  Congress  has  been 
reluctant  to  advance  them.  The  active  demand  for 
credit  since  1914  has  compelled  banks  to  increase  their 
capital  far  above  the  legal  requirements,  and,  in  fact, 
the  problem  in  banking  is  one  of  undercapitalization. 

In  the  case  of  a  business  corporation,  the  subscribed 
capital  may  be  far  in  excess  of  the  amount  actually 
paid  in,  for  the  law  usually  gives  the  directors  full 
discretion  in  demanding  payment  from  the  subscribers. 
No  such  choice  is  allowed  to  the  directors  of  national 
banks,  for  at  least  50  per  cent  of  the  stock  must  be 
actuallj^  paid  in  before  beginning  operation,  while  the 
remainder  may  be  contributed  within  five  months  in 
installments  of  10  per  cent  each.  Furthermore,  pay- 
ment must  be  effected  in  cash,  for  promissory  notes  or 
securities  are  not  acceptable.  These  regulations  gov- 
erning the  authorized,  subscribed,  and  paid-in  capital 
stock  of  banks  have  eliminated  the  evils  of  stock 
watering  so  common  in  the  general  field  of  business 
corporations. 

Another  feature  peculiar  to  bank  stock  is  its  uniform 
quality.  Banks  issue  only  common  stock,  while  the 
ordinary  business  corporations,  in  addition,  may  offer 
to  investors  preferred  stock  and  also  bonds  of  various 
kinds.     No  such  priority  is  recognized  among  bank 


64  BANKING  AND   BUSINESS 

stockholders,  who  are  all  placed  on  an  equal  footing. 
There  is  a  growing  tendency  in  modern  corporate 
practice  to  place  on  the  market  stocks  with  no  fixed 
par  value,  but  this  movement  has  not  affected  the 
business  of  banking,  for  in  this  field  it  is  still  customary 
to  issue  stock  at  a  par  value  of  one  hundred  dollars. 
As  a  result  of  all  these  safeguards,  bank  stock  proves 
generally  attractive  to  investors.  The  earnings  of 
banks  have  been  large  and  market  quotations  for  the 
stock  of  leading  banks  have  risen  far  above  the  par 
value. 

IV.  Surplus. 

Earnings  are  not  entirely  distributed  to  the  stock- 
holders of  the  bank,  for  a  conservative  management 
follows  the  pohcy  of  setting  aside  a  portion  to  form  a 
surplus  in  order  to  meet  unexpected  losses.  Surplus 
is  not  always  accumulated  from  earnings,  but  it  fre- 
quently is  paid  in  at  the  time  of  organizing  the  bank. 
In  fact,  the  National  Bank  Act  seeks  to  encourage  the 
estabhshment  of  an  initial  surplus  by  stipulating  that 
dividends  cannot  be  declared  until  10  per  cent  of  the 
net  profits  of  the  preceding  half  year  have  been  carried 
to  the  surplus  until  this  account  shall  amount  to 
20  per  cent  of  the  capital.  It  is,  therefore,  customary 
to  place  the  stock  of  a  new  bank  on  the  market  at  a 
quotation  of  120,  and  this  premium  from  the  start 
creates  the  necessary  surplus.  As  an  illustration:  the 
organizers  of  a  national  bank  are  authorized  to  issue 
1,000  shares,  and  if  these  are  sold  at  a  quotation  of 
120,  the  bank  would  start  with  $100,000  as  capital 
and  $20,000  as  surplus.  Under  this  plan  the  bank 
possesses  the  required  surplus  immediately,  and  the 
directors  are  soon  able  to  declare  dividends  if  profits 
warrant  this  step.    From  the  standpoint  of  the  stock- 


BANK  ORGANIZATION  65 

holders  another  advantage  is  derived  in  enlarging  sur- 
plus rather  than  capital,  since  the  former  involves  no 
liabihty  to  the  owners  of  bank's  stock.  It  is,  there- 
fore, quite  common  for  banks  to  accumulate  a  surplus 
far  in  excess  of  their  capital. 

V.  Stockholders. 

Although  stockholders  are  the  nominal  proprietors 
of  the  bank,  they  hold  a  position  relati\ely  unimportant, 
for  they  take  no  active  part  in  management.  Stock- 
holders have  access  to  a  few  records  of  the  bank.  They 
also  have  the  right  to  assemble  for  the  purpose  of  elect- 
ing new  directors  and  of  approving  general  pohcies. 
Originally  it  was  the  inherent  right  of  stockholders  to 
enact  the  by-laws  of  the  bank,  but  in  the  evolution  of 
corporate  organization  this  power  has  been  delegated 
to  the  directors.  Stockholders  are  naturally  entitled 
to  participate  in  profits,  which  they  receive  in  the  form 
of  dividends.  At  the  same  time  they  must  also  bear 
losses  if  these  are  serious  enough  to  force  the  bank  into 
the  hands  of  a  receiver.  In  the  case  of  bank  stock- 
holders this  situation  may  involve  heavy  loss  to  the 
stockholders,  for  they  are  under  double  liability.  The 
receiver,  acting  in  the  interest  of  creditors  of  a  bank 
which  has  failed,  may  assess  all  holders  of  the  stock 
for  a  sum  equaling  its  par  value. 

VI.  Directors. 

/.  Qualifications. 

The  stockholders  of  a  bank  choose  a  board  of  directors 
who  formulate  the  policies  of  the  institution.  They  are 
elected  for  a  term  of  one  year  by  the  shareholders  at 
their  annual  meeting,  which  is  usually  held  in  January. 
The  statutory  qualifications  of  a  director  are  the  fol- 


66  BANKING  AND  BUSINESS 

lowing:  (a)  citizenship,  (b)  residence,  (c)  holdings  of 
bank  stock.  Every  director  must  be  a  citizen  of  the 
United  States,  and  during  his  tenure  of  office  a  resident 
of  the  state  or  territory  where  the  bank  is  located. 
Three-fourths  of  the  board  of  directors  shall  have 
resided  in  the  state  or  territory  at  least  one  year  before 
their  election.  By  an  amendment  passed  in  1921  this 
residence  qualification  was  broadened  to  include  also 
the  area  within  fifty  miles  of  the  site  of  the  bank  re- 
gardless of  state  border  lines.  Thirdly,  every  director 
must  hold  not  less  than  five  shares,  if  the  bank  has  a 
capital  of  less  than  $25,000,  and  if  in  excess  of  this 
amount,  he  must  possess  at  least  ten  shares  of  the 
capital  stock.  This  is  merely  a  nominal  qualification, 
for  a  director  frequently  represents  interests  which 
control  a  large  block  of  the  bank's  stock. 

2.  Duties. 

The  list  of  the  directors  may  serve  as  a  valuable 
factor  in  increasing  the  bank's  business,  for  the  nomina- 
tion of  citizens  of  character  and  ability  will  inspire  the 
confidence  of  the  community  and  will  thus  induce 
depositors  to  place  their  funds  with  the  bank.  The 
leading  industries  of  the  community  should  have 
representation  on  the  board  of  directors,  not  only  to 
attract  their  business,  but  also  to  keep  the  bank  in 
touch  with  the  condition  of  local  economic  interests. 
This  information  is  of  utmost  importance  to  the  board, 
for  its  main  function  is  to  express  its  approval  or  dis- 
approval of  all  loans  proposed  by  the  officers  of  the 
bank.  The  directors  are  the  sentinels  who  must 
guard  against  extending  loans  to  unworthy  borrowers. 
Directors  also  have  complete  control  over  the  per- 
sonnel of  the  bank  and  have  final  jurisdiction  over 
appointments  and  dismissals  of  members  of  the  staff. 

Another  executive  function  of  the  board,  is  periodi- 


BANK  ORGANIZATION  67 

cally  to  examine  the  financial  condition  of  the  bank. 
This  is  more  than  a  mere  formahty,  for  it  is  customary 
to  retain  outside  auditors  to  scrutinize  records  and 
ledgers  and  to  submit  a  detailed  report  of  their  findings. 

In  their  legislative  capacity  the  directors  usually 
enact  the  by-laws  of  the  bank.  These  regulations  aim 
to  secure  uniformity  in  operations.  The  by-laws  de- 
fine the  powers  which  officers  may  exercise,  the  rules 
which  directors  must  observe  at  their  meetings,  and  the 
procedure  which  shareholders  must  follow  in  their 
annual  assemblies.  Also,  dividends  can  be  declared 
only  by  action  of  the  directors.  In  general,  they  may 
buy  and  sell  property,  enter  into  contracts,  and  a^•ail 
themselves  of  any  power  which  is  specifically  conferred 
upon  the  bank  under  its  charter. 

The  organization  of  the  board  depends  upon  its 
volume  of  business.  In  the  case  of  a  small  bank  the 
board  may  consist  of  the  legal  minimum  of  five  mem- 
bers, and  they  may  meet  as  a  single  body  at  infrequent 
intervals.  On  the  other  hand,  a  metropohtan  bank  is 
governed  by  a  board  of  about  twenty-five  members, 
who  in  turn  are  divided  into  small  committees,  each 
specializing  in  one  or  more  of  the  duties  described 
above.  Groups  of  directors  thus  serve  on  personnel, 
auditing,  and  discount  conmiittees.  The  discount 
committee,  which  passes  on  all  applications  for  loans, 
is  the  most  active,  and  in  a  large  bank  may  hold  daily 
meetings. 

For  these  services  directors  receive  no  salary,  but  it 
is  customary  to  allow  them  a  ten-dollar  gold  piece  as 
an  honorarium.  Directors  who  seek  a  larger  return  by 
influencing  the  action  of  the  board  in  granting  loans 
to  their  own  business  interests,  or  in  withholding  ad- 
vances to  competing  firms,  commit  an  abuse  of  power 
which  is  not  specifically  prohibited  by  any  section  of  the 
National  Bank  Act,  but  is  nevertheless  restrained  by 


68  BANKING  AND  BUSINESS 

the  action  of  the  Comptroller  of  the  Currency  in  requir- 
ing banks  to  state  in  their  reports  the  full  amount  of 
loans  granted  to  their  directors. 

3.  Liahilities. 

Although  acting  without  large  compensation,  a  bank 
director  assumes  individual  liabilities  which  may  prove 
costly  under  conditions  of  adversity.  As  in  the  case 
of  any  other  corporation,  the  director  of  a  bank  must 
exercise  an  ordinary  degree  of  care  in  the  general 
administration  of  the  institution.  Naturally,  the 
director  of  a  corporate  organization  cannot  be  expected 
to  undertake  personally  the  details  of  actual  manage- 
ment, and  these  duties  must  necessarily  be  delegated 
to  officers  and  other  agents.  However,  directors  of  a 
bank  have  been  held  individually  hable  for  such  acts 
as  neglecting  affairs,  assenting  to  excessive  loans,  and 
pubhshing  false  reports.  One  director  absented  him- 
self from  board  meetings  for  five  years,  during  which 
time  the  business  was  grossly  mishandled  by  the  officers. 
The  court,  therefore,  adjudged  the  director  fully  re- 
sponsible, since  he  had  not  exercised  reasonable  care 
and  dihgence.  A  similar  view  was  taken  in  the  case 
of  a  bank  in  which  it  was  the  practice  to  grant  oJSicers 
loans  unwarranted  in  amount.  The  Comptroller's 
office  brought  these  facts  to  the  attention  of  the  board 
of  directors,  but  no  action  was  taken,  with  the  result 
that  the  bank  finally  became  insolvent  and  the  directors 
were  judged  liable  for  the  irregularities.  Damages  have 
also  been  collected  by  a  person  who  had  purchased 
bank  stock  on  the  strength  of  a  statement  sho"^dng  the 
financial  condition  of  the  institution.  In  this  case,  the 
director  suffered  loss  for  lending  his  name  to  a  report 
containing  false  items.  In  general,  both  state  and 
national  laws  are  quite  stringent  in  fixing  the  Uabilities 
of  bank  directors,  and  the  com'ts  in  recent  yeai's  have 


BANK  ORGANIZATION  69 

placed  a  broad  construction  upon  these  obligations. 
Undoubtedly  this  attitude  has  led  directors  of  banks 
to  exercise  a  supervision  more  stringent  than  that  ap- 
plied in  other  corporations,  and  so  bank  failures  during 
the  past  decade  ha\'e  been  materially  lessened. 

^.  Interlocking  Directorates. 

The  tendency  toward  integration  which  has  in- 
fluenced the  evolution  of  all  lines  of  "big  business"  has 
also  affected  the  development  of  financial  corporations. 
One  method  of  ehminating  competition  and  securing 
community  of  interest  has  been  to  appoint  the  same 
directors  on  the  boards  of  the  banks  over  which  control 
is  sought.  This  practice  became  quite  extensive,  and 
finally,  in  1914,  Congress  passed,  as  part  of  the  general 
anti-trust  legislation  of  the  time,  the  Clayton  Act, 
which  forbade  these  "interlocking  directorates"  for 
certain  classes  of  banks.  This  statute  prohibited  any 
person  from  acting  at  the  same  time  as  director,  officer, 
or  employee  in  two  or  more  banks  or  trust  companies 
operating  under  the  laws  of  the  United  States  and 
having  deposits,  capital,  surplus,  and  undi\dded  profits 
in  excess  of  $5,000,000.  The  same  restriction  applied 
to  banks  or  trust  companies  located  within  the  same 
city  if  it  possessed  a  population  over  200,000.  In 
order  to  observe  the  provisions  of  the  Act,  many 
persons  who  held  several  directorates  in  large  banks 
withdrew  from  these  offices. 

The  original  Clayton  Act  caused  embarrassment 
especially  to  metropolitan  banks,  and  in  1916  its  terms 
were  rendered  less  exacting  by  the  Kern  Amendment. 
The  statute  thus  revised  permitted  individuals  simul- 
taneously to  serve  two  or  more  banks  which  were  mem- 
bers of  the  Federr^l  Reserve  system  provided  these 
institutions  were  not  in  "substantial  competition." 
The  duty  of  interpreting  the  Act  was  assigned  to  the 


70  BANKING  AND   BUSINESS 

Federal  Reserve  Board.  If  a  person  now  desires  to  hold 
directorships  in  two  or  more  large  banking  institutions, 
he  first  presents  his  application  to  the  Federal  Reserve 
Board,  which  determines  whether  or  not  competition 
is  being  restrained.  In  rendering  these  decisions  the 
board  has  followed  a  liberal  policy.  Comparatively 
few  applications  have  been  rejected,  but  many  changes 
have  occurred  through  voluntary  action  of  directors. 

VII.  The  Bank  Officers. 

1.  President. 

The  function  of  the  board  of  directors  is  essentially 
one  of  general  supervision  of  the  bank's  affairs,  for 
actual  management  is  delegated  to  an  executive  staff. 
The  president  is  the  active  head  of  the  organization 
and  serves  as  the  connecting  hnk  between  directors 
and  employees  of  the  bank.  There  is  always  a  close 
relationship  between  the  directors  and  the  president. 
Under  the  National  Bank  Act  he  must  be  a  member  of 
the  board  and  may  also  preside  at  its  meetings.  It  is 
the  tendency  among  larger  banks  to  reUeve  the  presi- 
dent of  the  duties  of  chairmanship  and  to  designate 
another  director  for  the  office.  This  appointee  may  be 
a  president  emeritus  who  is  too  advanced  in  years 
for  active  service,  but  who  is  well  qualified  by  experi- 
ence to  give  mature  counsel.  In  a  few  large  banks 
the  chairman  of  the  board  is  an  active  operating  officer 
and  actually  has  the  powers  of  the  president,  who,  in 
such  banks,  becomes  a  subordinate  officer.  Practice 
seems  to  favor  the  plan  of  vesting  the  duties  of  both 
president  of  the  bank  and  chairman  of  the  board  in 
one  individual. 

The  board  frequently  selects  as  president  from  its 
own  number  one  who  has  been  successful  in  operating 
a  local  enterprise.     He  has  thus  acquired  considerable 


BANK  ORGANIZATION  71 

business  experience  which  can  be  applied  to  advantage 
in  directing  the  poUcies  of  the  bank.  However,  his 
understanding  of  the  technical  phases  of  banking  is 
often  confined  to  the  limited  knowledge  which  he  has 
gathered  from  attendance  at  meetings  of  the  board  of 
directors.  As  such  training  is  insufficient  for  a  full 
mastery  of  the  technical  details  of  operation,  it  has 
become  the  pohcy  of  some  institutions  to  elevate  to 
the  presidency  an  officer  who  has  risen  from  the  lower 
ranks.  In  selecting  a  president  the  larger  banks 
generally  prefer  the  trained  banker  to  the  successful 
business  man. 

The  duties  of  the  president,  as  stated  in  the  provisions 
of  the  National  Bank  law,  are  very  limited,  and  in  fact 
there  is  little  legal  difference  between  his  power  and 
that  of  any  other  director.  The  president  is  regarded 
as  the  representative  of  the  bank  in  the  event  of  litiga- 
tion, and,  therefore,  is  given  the  right  to  retain  counsel, 
to  defend  the  bank,  or  bring  suit  in  its  name.  Al- 
though this  is  the  only  inherent  power  granted  by  law, 
the  president  in  actual  practice  assumes  a  number  of 
important  duties.  While  these  functions  thus  remain 
undefined  by  law,  their  extent  is  detemiined  rather  by 
the  custom  of  the  bank  or  the  will  of  the  president 
himself.  As  he  is  a  member  of  the  board  of  directors, 
he  is  in  a  position  to  influence  the  shaping  of  the 
bank's  general  policy.  In  fact,  he  is  the  intermediary 
who  communicates  the  wishes  of  the  board  to  the 
members  of  the  staff.  Subject  to  the  final  approval 
of  the  directors,  the  president  passes  upon  loans  made 
to  borrowers,  and  also  invests  the  surplus  funds  of  the 
bank.  The  president  must  act  as  the  representative 
of  the  bank  in  its  dealings  with  the  outside  public,  and 
in  this  capacity  he  is  able  to  attract  profitable  business 

and  new  accounts  to  the  bank. 
6 


72  BANKING  AND   BUSINESS 

S.  Vice-President. 

At  times  the  vice-president  is  also  selected  from  the 
board  of  directors.  This  plan  results  in  a  close  connec- 
tion between  the  vice-president  and  the  board.  A  vice- 
president  is  occasionally  appointed  because  of  his 
affiliation  with  a  family  controlHng  prominent  local 
business  interests.  Under  such  circumstances  he  is 
expected  to  draw  these  accounts  to  the  bank,  but  other- 
wise he  may  be  called  upon  to  perform  little  actual 
service.  However,  many  vice-presidents  are  experi- 
enced executives  selected  from  among  the  junior  officers 
of  the  bank  or  from  outside  institutions.  The  number 
of  vice-presidents  will  vary  according  to  the  size  of  the 
organization — from  one  in  the  case  of  a  small  institu- 
tion to  half  a  dozen  or  more  in  a  large  bank  which  has 
grown  through  expanding  its  business  or  through  con- 
solidating several  competitors. 

In  a  small  bank  the  vice-president  may  act  as  the 
representative  of  the  president,  or  as  assistant  in  carry- 
ing out  the  duties  of  granting  loans,  securing  new 
accounts,  and  directing  the  general  policy  of  the  bank. 
In  a  large  bank  having  several  vice-presidents  it  is  pos- 
sible to  distribute  these  duties  so  that  the  best  results 
may  be  attained  through  either  territorial  or  depart- 
mental speciaHzation.  A  vice-president  may  have 
acquired  an  intimate  knowledge  of  the  economic  and 
financial  conditions  in  a  certain  section  of  the  country 
through  previous  residence  or  business  experience,  and 
so  he  is  given  jurisdiction  over  the  transactions  in  this 
territory.  The  principle  of  specialization  is  also  ap- 
plied in  assigning  to  a  vice-president  the  supervision 
of  a  single  department  such  as  the  foreign,  bond,  or 
trust  division  in  which  he  has  shown  particular  aptitude. 

3.  Cashier. 

The  position  of  the  cashier  in  a  bank  really  involves 


BANK  ORGANIZATION  73 

all  the  duties  usually  attaching  to  the  office  of  secretary, 
chief  clerk  and  treasurer  combined.  While  the  posi- 
tion of  secretary  can  be  found  on  the  staff  of  any 
ordinary  corporation,  this  office  rarely  appears  in  any 
banking  institution  other  than  a  trust  company.  The 
cashier  of  the  bank  acts  as  secretary  to  the  board  of 
directors  and  at  times  is  a  member  of  this  body.  In 
this  capacity  he  prepares  reports  and  statements  for 
the  consideration  of  the  board  and  compiles  the 
minutes  of  meetings.  As  chief  clerk  he  has  general 
control  over  internal  operation  and  responsibility  for 
carrying  out  the  policies  dictated  by  the  board,  the 
president,  and  the  vice-presidents.  He  therefore  has 
jurisdiction  over  the  clerical  staff,  routine  office  corre- 
spondence, files  and  records  of  the  bank.  As  his  name 
implies,  the  cashier  has  control  over  the  funds  of  the 
bank  and  so  is  empowered  to  sign  checks  for  paying 
debts  assumed  in  the  course  of  daily  business.  In  fact, 
the  cashier  in  every  respect  is  treasurer,  for  he  is  in 
charge  of  the  bank's  safety  vaults.  As  it  is  thus 
essential  for  the  cashier  to  know  the  intricacies  of  bank 
routine,  he  is  always  an  internal  appointee  with  wide 
experience  in  banking  technic. 

The  president,  vice-president,  and  cashier  of  the 
bank  are  the  only  officers  recognized  by  the  National 
Bank  Act,  and  they  alone  may  serve  as  legal  agents 
with  authority  to  bind  the  bank.  These  general 
executives  may  be  aided  in  their  duties  by  various 
other  officers.  On  the  staff  of  the  large  banks  are 
found  assistant  vice-presidents  and  assistant  cashiers 
and  department  managers  who  may  serve  as  personal 
aides  to  their  ^especti^'e  superior  officers.  In  addition, 
there  are  a  number  of  tellers  and  clerks  connected  with 
the  various  departments  of  the  bank.  Their  duties  are 
determined  by  the  workings  of  their  separate  depart- 
ments described  in  detail  in  the  following  chapter. 


chaptp:r  VI 

BANK  OPERATION 

I.  Function  of  a  Commercial  Bank. 

The  previous  chapter  has  traced  the  organization 
of  a  commercial  bank  and  has  touched  upon  its  ad- 
ministration by  explaining  the  duties  of  the  officers 
Continuing  the  general  survey  of  the  commercial  bank, 
the  next  step  is  to  analyze  the  actual  working  of  its 
various  departments.  These  operations  could  be  ex- 
amined to  advantage  from  the  viewpoint  of  the  banker 
himself,  but  it  is  the  purpose  of  this  book  to  present 
the  subject  rather  from  the  position  of  the  depositor. 
Therefore,  the  following  study  of  bank  operation  will 
be  external  rather  than  internal  in  treatment,  and  will 
present  only  those  features  of  technical  practice  which 
are  essential  to  an  understanding  of  the  principles 
underlying  commercial  banking. 

As  we  have  already  seen,  the  central  function  of  a 
commercial  bank  is  to  substitute  its  own  credit,  which 
has  general  acceptance  in  the  business  community, 
for  the  individual's  credit,  which  has  only  Umited 
acceptability.  How  this  single  function  is  exercised 
in  actual  practice  may  readily  be  understood  by  view- 
ing the  relation  between  a  bank  and  a  depositor.  Let 
us  assume  that  A  of  New  York  City  has  sold  a  bill  of 
goods  worth  $100  to  B  of  Boston.  The  latter  may 
settle  with  A  by  giving  him  cash,  a  check,  or  a  promis- 
sory note.  If  payment  be  made  in  cash,  A  generally 
uses  this  money  to  build  up  his  account  at  his  bank, 


BANK  OPERATION  75 

and  so  he  brings  it  to  the  receiving  teller,  who  adds 
the  amount  of  the  deposit  to  his  credit  with  the  bank. 
A  now  possesses  $100  of  bank  credit  which  he  may 
withdraw  at  any  time.  If  he  wishes  to  transfer  this 
sum  to  one  of  his  creditors,  he  will  draw  a  check  in 
favor  of  the  latter,  who  may  present  the  instrument 
for  payment  directly  to  the  paying  teller  of  the  drawee 
bank. 

The  transaction  thus  described  has  involved  onlj''  the 
receiving  and  the  paying  of  a  deposit  of  cash.  But 
modern  business  is  not  generally  conducted  on  a  mere 
cash  basis,  and  its  financial  aspects  cannot  be  under- 
stood by  so  simple  an  illustration.  As  mentioned 
above,  B  may  also  reimburse  A  by  means  of  a  check 
drawn  in  this  instance  on  a  bank  located  in  Boston. 
A  now  holds  a  claim  on  Boston  funds  which  naturally 
he  prefers  to  have  available  for  his  use  in  New  York. 
One  way  to  secure  this  purpose  would  be  to  sell  his 
claim  of  $100  to  some  one  who  owes  a  similar  amount 
to  a  creditor  in  Boston.  However,  an  easier  method 
is  merely  to  deposit  the  check  with  his  New  York  bank, 
which  is  continually  engaged  in  offsetting  such  claims 
with  institutions  in  other  financial  centers.  Thus, 
without  any  further  trouble  to  A,  his  bank  accepts 
the  deposit  of  the  check,  credits  his  account,  and  then 
allows  him  to  draw  against  the  sum.  This  service 
by  which  banks  secure  payment  of  claims  on  one 
another  is  the  operation  of  exchange. 

Another  aspect  of  banking  practice  is  illustrated  by 
the  third  method  of  payment,  by  which  B  gives  his 
creditor  a  note  promising  to  pay  $100  within  a  certain 
number  of  days  after  date.  A  thus  holds  a  claim 
on  future  funds,  but  this  will  be  of  little  value  if  he 
must  meet  immediate  obligations  of  his  own  creditore. 
A  thereupon  takes  the  promissory  note  to  his  bank, 
which  first  tests  the  financial  responsibility  of  both 


76  BANKING  AND   BUSINESS 

parties.  If  satisfied,  the  bank  credits  the  account  of 
A  and  thus  permits  him  to  make  withdrawals  for  the 
payment  of  his  debts.  The  bank  has  thus  substituted 
its  own  credit  for  that  of  B,  and  has  given  A  the  right 
to  immediate  funds  in  place  of  his  claim  to  future 
funds.     This  is  the  process  of  ''discounting." 

In  this  illustration  the  bank  has  discounted  the  note 
by  simply  adding  the  sum  to  A's  deposit  account.  If 
the  bank  is  chartered  under  the  national  law,  it  may 
extend  credit  to  A  not  only  by  increasing  his  deposit, 
but  also  by  giving  him  its  notes,  which  circulate 
throughout  the  community.  This  issue  power  of 
national  banks  has  declined  in  importance  since  the 
inauguration  of  the  Federal  Reserve  system,  which 
has  provided  for  the  eventual  elimination  of  national- 
bank  notes  and  the  circulation  of  a  new-  form  of  cur- 
rency. Thus  the  three  operations  of  deposit,  exchange, 
and  discount  alone  have  a  significance  in  banking 
practice.  The  following  sections  of  this  chapter  will 
deal  with  a  bank's  departments  and  subdivisions 
which  carry  out  these  several  processes. 

II.  Receiving  Teller. 

The  work  of  the  receiving  teller  offers  a  logical  point 
to  begin  a  study  of  the  bank's  operations,  for  his 
department  is  the  first  to  handle  the  cash  and  credit 
instruments  presented  by  customers.  In  tracing  the 
procedure  of  this  department  it  is  well  to  start  with  the 
preparation  of  the  deposits  by  the  customer.  He 
counts  the  cash,  indorses  all  checks,  drafts,  and  promis- 
sory notes,  and  lists  the  various  amounts  on  a  deposit 
slip  or  ticket  which  acts  as  a  record  of  the  items  offered 
to  the  receiving  teller.  The  depositor  also  presents  his 
pass  book  in  which  the  receiving  teller  wTites  his  en- 
tries.    In  addition  to  serving  as  a  record  of  deposits, 


BANK  OPERATION  77 

the  pass  book  is  used  to  settle  periodicallj^  the  account 
between  customer  and  bank.  In  the  interest  of  both 
parties,  this  settlement  or  reconcilement  is  effected 
quite  frequently,  for  errors,  irregularities,  and  at  times 
forgeries  may  arise  in  directing  the  continuous  flow  of 
credit  instruments.  The  pass  book  as  means  of 
reconciling  accounts  is  now  giving  way  to  the  use  of 
the  statement  system,  whereby  the  bank  sends  the  cus- 
tomer his  returned  checks  or  vouchers,  accompanied 
by  a  record  listing  all  his  deposits  and  withdrawals. 
The  statement  is  usually  sent  every  month,  but  this 
interval  of  time  may  vary  from  a  week  to  three  months, 
depending  upon  the  activity  of  the  account.  Whether 
the  pass  book  or  the  statement  is  used,  the  principle 
of  reconcilement  consists  merely  of  presenting  to  the 
customer  his  credits  with  the  bank  as  evidenced  by 
deposits,  his  debits  as  represented  by  checks,  and  the 
balance  or  net  difference  between  these  two  items. 
The  customer's  deposit  is  entered  in  three  records: 
(1)  the  slip  indicating  his  deposit,  (2)  the  pass  book 
acknowledging  it,  (3)  the  statement  summarizing  his 
account.  Since  the  receiving  teller  must  handle 
deposits  with  speed,  he  cannot  verify  each  one  as  it  is 
presented  to  him  at  the  window,  and  so  this  task  is 
later  performed  by  his  assistants.  However,  it  would 
be  impracticable  to  wait  until  closing  time  to  compare 
deposits  with  the  corresponding  slips,  so  they  are 
proved  soon  after  presentation  in  lots  of  twenty- 
five  slips  or  more  by  what  is  known  as  the  "batch," 
or  "block,"  system.  After  the  deposits  and  the  slips 
have  been  duly  proved,  the  next  step  is  to  allocate  the 
items  among  the  other  departments  of  the  bank.  Coin 
and  bills  are  transferred  to  the  paying  teller,  while 
checks,  notes,  and  drafts  are  sorted  and  then  dis- 
tributed to  the  various  departments  which  handle  the 
collection  of  these  items.     As  the  city  banks  have 


78  BANKING  AND   BUSINESS 

many  out-of-town  customers,  a  large  volume  of  de- 
posits are  received  through  the  mail.  These  items  are 
handled  by  a  mail  teller,  who  receives,  proves,  and  sorts 
the  deposits  in  about  the  same  manner  as  the  receiving 
teller.  Instead  of  a  slip,  the  deposits  are  accompanied 
by  a  memorandum  known  as  a  letter  of  advice. 

III.  Paying  Teller. 

Through  deposits  of  cash  and  credit  instruments  the 
customer  builds  up  his  account  with  the  bank.  This 
bank  credit  confers  upon  the  depositor  the  right  to 
draw  checks  with  which  to  settle  his  debts  and  at  the 
same  time  impose  upon  the  bank  the  obhgation  to 
pay  those  checks  on  demand  in  cash.  The  responsi- 
bility for  the  outflow  of  cash  is  assigned  to  the  paying 
teller  of  the  bank.  In  some  respects  his  position  is 
just  the  reverse  of  that  of  the  receiving  teller.  The 
receiving  teller  deals  only  with  the  bank's  customers, 
for  they  alone  bring  deposits  to  his  window.  On  the 
other  hand,  the  paying  teller  comes  into  contact  with 
the  general  public,  for  the  depositor  of  the  bank  may 
draw  checks  in  favor  of  any  one  person,  and  such 
a  payee  may  then  order  the  paying  teller  to  honor  the 
instrument.  The  work  of  the  receiving  teller  involves 
less  risk,  for  errors  committed  at  his  window  may 
readily  be  discovered  by  assistants  later  in  the  day 
and  then  corrected.  But  if  the  paying  teller  once  over- 
pays the  amount  of  the  checks  presented  to  liim,  this 
disbursement  generally  is  beyond  his  control  to  adjust. 

The  general  function  of  the  paying  teller  is  to  effect 
all  disbursements  of  cash  and  shipments  of  currency 
for  the  account  of  the  bank.  These  payments  are 
made  for  the  following  purposes:  (1)  settlement  of 
balances  o^ving  to  other  banks,  (2)  cashing  of  checks, 
(3)  preparation  of  pay  rolls,  (4)  certification  of  checks. 


BANK   OPERATION  79 

In  all  banks  the  paying  teller  has  sole  responsibility 
for  honoring  checks  drawn  by  the  customers.  The 
payees  usually  deposit  these  instruments  in  their  own 
banks,  which  present  them  on  the  following  day  for 
payment  through  the  local  clearing  house.  These 
clearing-house  balances  owing  to  other  banks  were 
formerly  paid  in  cash  by  the  paying  teller,  but  they  are 
now  settled  by  simple  bookkeeping  entries  on  the 
ledgers  of  the  Federal  Reserve  Bank. 

A  check  may  be  presented  by  a  payee  directly  at  the 
window  of  the  drawee  bank,  w^hich  is  then  called 
upon  to  cash  it  if  the  holder  can  pro^'e  that  he  is 
entitled  to  the  money.  In  making  these  disbursements 
the  paying  teller  must  note  carefully  such  factors  re- 
lating to  the  instrument  as  the  signature,  indorsement, 
date,  amount,  balance  of  the  account,  and  stop-pay- 
ment orders. 

The  signature  of  the  drawer  is  verified  from  a  file 
containing  specimens  of  the  handwriting  of  all  the 
bank's  customers.  When  a  check  is  presented  by  a 
person  other  than  the  drawer,  it  is  good  practice  to 
insist  upon  indorsement  on  the  reverse  side,  even  if  the 
instrument  is  filled  out  to  bearer.  If  a  check  payable 
to  order  is  presented  by  a  stranger,  it  is  necessary 
for  him  to  prove  that  he  is  the  designated  party.  This 
identification  may  be  secured  by  exhibiting  documents 
such  as  personal  letters  and  business  cards,  or  by 
securing  an  introduction  from  a  customer  of  the  bank. 

The  paying  teller  must  also  observe  the  date  and 
guard  against  post-  or  ante-dated  checks.  If  the 
drawer  has,  either  through  intent  or  error,  postdated 
the  instrument  by  an  advance  date,  it  is  the  duty  of  the 
bank  to  withhold  funds  until  the  specified  time  arrives. 
On  the  other  hand,  if  the  holder  does  not  present  a 
check  immediately,  it  becomes  antedated,  or  stale,  but 
payment  is  usually  made  by  the  bank.     The  teller 


80  BANKING  AND   BUSINESS 

carefully  examines  the  amount  of  the  check  for  any 
careless  discrepancy  between  the  sum  written  in  num- 
bers and  in  words,  and  for  deliberate  raising  or  altera- 
tion. The  extent  of  the  customer's  credit  with  the 
bank  is  occasionally  investigated  to  find  out  whether 
his  balance  justifies  the  payment  of  the  checks  which 
he  has  drawn.  At  times  a  customer  draws  a  check 
to  an  amount  greater  than  the  funds  to  his  credit, 
and  this  excess  is  known  as  an  overdraft,  which  the 
bank  may  refuse  to  honor.  Funds  are  also  withheld 
from  the  payee  when  the  drawer  issues  a  stop-payment 
order.  This  notice  to  the  bank  is  written  by  the  cus- 
tomer when  he  seeks  to  prevent  payment.  In  sum- 
mary, the  paying  teller  in  cashing  checks  must  guard 
against  forgery,  misidentity,  postdating,  overpayment, 
alteration,  overdraft,  and  an  order  to  stop  payment. 

The  paying  teller's  department  also  prepares  the  pay 
roll  for  those  customers  of  the  bank  who  employ  labor 
on  a  large  scale.  These  payments  are  seldom  made  by 
checks,  but  usually  in  cash.  It  is  necessary  to  deter- 
mine in  advance  the  community's  demand  for  the 
various  denominations  of  bills  and  the  several  kinds 
of  small  change.  As  the  work  of  preparing  pay  rolls 
involves  considerable  clerical  assistance,  it  is  not 
unusual  for  banks  to  insist  that  requests  be  submitted 
by  their  customers  several  days  in  advance  of  the  date 
of  payment. 

Still  another  duty  of  the  paying  teller  is  the  certifica- 
tion of  checks.  As  previously  mentioned,  the  ordinary 
check  is  merely  an  order  drawn  by  the  customer  against 
his  account  with  the  bank,  but  the  holder  of  this  instru- 
ment has  no  positive  guaranty  that  it  vnll  be  honored 
by  the  bank,  for  it  will  refuse  payment  if  the  account 
has  been  overdrawn  or  if  a  stop-payment  order  has  been 
issued.  In  certain  types  of  business  transactions, 
such  as  sales  of  real  estate,  the  seller  naturally  has  the 


BANK  OPERATION  81 

right  to  demand  payment  before  he  surrenders  his 
property  to  the  buyer.  The  transaction  may  be  set- 
tled by  payment  in  actual  cash,  but  it  is  customary  to 
accept  reimbursement  by  a  certified  check.  This  is  the 
same  in  form  as  an  ordinary  check,  but  on  its  face  the 
paying  teller  of  the  bank  has  signed  his  name  and 
stamped  the  expression  "certified"  or  words  of  similar 
meaning.  This  act  of  the  paying  teller  signifies  that 
the  bank  has  withdrawn  the  specified  sum  of  money 
from  the  account  of  the  drawer  of  the  check  and  has 
set  it  aside  for  the  benefit  of  the  payee.  The  obliga- 
tion to  pay  has  thus  been  transferred  from  the  individ- 
ual to  the  bank. 

A  number  of  banks  combine  the  work  of  the  recei\'ing 
and  paying  tellers  in  what  is  known  as  the  unit  system. 
The  tellers'  windows  are  arranged  in  groups  of  the 
alphabet  such  as  A-F,  G-0,  Q-W,  and  accordingly  cus- 
tomers leave  deposits  and  cash  checks  at  the  same 
window.  The  unit  plan  saves  time  for  the  customer 
and  facilitates  the  work  of  the  bank,  since  the  tellers 
handle  a  smaller  number  of  accounts  and  thus  become 
more  familiar  with  them. 

IV.  Classification  of  Exchange  Items. 

The  receiving  teller  transfers  deposits  of  cash  to  the 
paying  teller,  who  in  turn  uses  the  money  to  meet 
the  claims  drawn  against  the  bank.  The  receiving 
teller  also  handles  deposits  of  credit  instruments  such 
as  checks,  promissory  notes,  and  drafts,  which  the 
bank  presents  to  the  drawee  for  payment  and  credits 
to  the  account  of  its  customer. 

These  instruments  are  classified  on  a  basis  determined 
by  noting  whether  the  customer  recei\'ed  credit  to  the 
account  before  or  after  presentation  has  been  made. 
If  the  bank  gives  him  immediate  credit  before  presenta- 


82  BANKING  AND  BUSINESS 

tion  of  the  instrument,  it  is  described  as  a  "cash" 
item  against  which  the  depositor  may  draw  his  checks 
at  any  time.  On  the  other  hand,  if  the  bank  with- 
holds the  credit  and  does  not  permit  the  customer  to 
draw  against  the  deposit  of  the  instrument  until  it  has 
actually  been  paid,  it  is  then  termed  a  "collection" 
item.  In  other  words,  the  cash  item  allows  the 
depositor  immediate  credit,  while  the  collection  item 
gives  him  only  deferred  credit. 

In  general,  cash  items  include  all  instruments  which 
are  due  or  past  due,  while  collection  items  consist  of 
claims  which  have  not  yet  matured.  For  example,  a 
check  is  a  cash  item,  for  it  is  an  order  which  a  bank 
must  pay  on  demand.  A  collection  item  may  be 
illustrated  by  a  draft  which  has  been  deposited  several 
days  before  its  maturity. 

These  instruments  may  be  further  classified  as  city 
or  country,  depending  upon  the  place  where  reimburse- 
ment is  made.  A  city  item  is  one  which  is  presented 
in  the  same  locality  as  the  collecting  bank,  while  a 
country  item  is  payable  anywhere  beyond  the  imme- 
diate vicinity.  The  classes  of  exchange  items  handled 
by  a  bank  may  be  grouped  as  follows: 

^.  I  cash 

^"■y  1  coUection 


m^ 


Country      I 


cash 
collection 


In  order  to  trace  the  entire  procedure  of  forwarding 
these  items  for  ultimate  payment,  it  would  be  necessary 
to  extend  the  study  beyond  a  survey  of  the  operations 
of  one  bank  to  a  complete  analysis  of  the  relations 
among  banks.  This  subject  will  be  reserved  for 
treatment  in  Chapter  XV,  and  for  the  present  the  dis- 


BANK  OPERATION  83 

cussion  will  be  confined  to  those  departments  within 
the  bank  which  prepare  the  items  for  collection. 

V.  Collection  of  City  Items. 

Most  important  among  the  city  cash  items  are  checks 
drawn  on  other  local  banks  which  are  also  receiving 
checks  from  their  own  customers.  Banks  in  the  same 
community  are  thus  mutually  engaged  in  presenting 
and  at  the  same  time  paying  claims.  As  the  amount 
of  checks  deposited  by  a  customer  is  credited  imme- 
diately to  his  account,  the  bank  seeks  payment  for 
these  claims  from  the  drawee  banks  as  quickly  as 
possible.  In  order  to  present  these  items  to  other 
banks  for  payment  and  at  the  same  time  to  receive  in 
exchange  other  items  on  which  reimbursement  is  due, 
banks  have  organized  themselves  into  clearing-house 
associations.  A  clearing  house  maintains  a  meeting 
place  where  the  clerks  of  banks  which  are  members 
of  the  association  exchange  reciprocally  checks  drawn 
on  one  another  and  settle  differences  in  the  totals  of 
these  claims. 

The  handling  of  the  city  cash  items  inside  the  bank 
involves  the  preparation  of  the  claims  due  to  the 
bank  and  the  payment  of  items  owed  by  the  bank. 
These  operations  may  best  be  explained  by  tracing  the 
course  of  a  check  from  the  time  it  is  drawn  until  it  is 
finally  paid.  B  draws  his  check  on  the  Y  Trust  Com- 
pany in  favor  of  A,  who  deposits  it  with  the  X  National 
Bank  of  New  York.  The  receiving  teller  sends  the 
deposit  slip  to  the  bookkeeper,  who  credits  the  amount 
to  A's  account  and  turns  the  check  over  to  the  depart- 
ment preparing  items  for  the  clearing  house.  The  first 
step  is  to  stamp  on  all  checks  an  indorsement  which 
reads,  "Received  payment  through  the  New  York 
Clearing  House,  prior  indorsements  guaranteed,  De- 


84  BANKING  AND   BUSINESS 

cember  1,  1921,  The  X  National  Bank  of  New  York." 
This  is  an  unqualified  indorsement  by  which  the  bank 
guarantees  the  validity  of  all  the  previous  signatures 
written  on  the  instrument,  and  further  acknowledges 
the  receipt  of  payment  from  the  drawee  bank.  It  may 
happen  that  a  signature  proves  invalid  and  payment 
is  eventually  refused  by  the  bank  on  which  the  check 
is  drawn.  As  this  contingency  arises  so  seldom  among 
the  thousands  of  checks  which  are  daily  exchanged, 
the  above  indorsement  is  stamped  on  all  items  sent 
through  the  clearing  house.  To  the  usual  indorsement 
is  added  the  special  clearing-house  number  by  which 
each  member  is  designated  rather  than  by  its  full 
name.  Next  the  checks  are  sorted  according  to  drawee 
banks,  or  really  according  to  their  respective  clearing- 
house numbers.  The  check  on  the  Y  Trust  Company 
is  placed  with  the  others  draw^n  on  this  bank.  When 
the  distribution  has  been  completed,  the  checks  on 
each  bank  are  then  placed  in  a  large  envelope  to 
which  is  attached  the  exchange  slip  showing  the  amount 
of  each  check.  At  a  given  time  in  the  morning  all 
the  envelopes  are  brought  to  the  clearing  house,  where 
the  items  are  exchanged  among  the  banks.  The  de- 
livery clerk  of  the  X  National  Bank  hands  over  the 
proper  envelope  to  the  settling  clerk  of  the  Y  Trust 
Company,  which  by  this  act  of  acceptance  acknowl- 
edges the  total  debt  as  evidenced  by  the  checks  con- 
tained in  the  envelope. 

With  the  checks  now  in  the  possession  of  the  drawee 
bank  the  next  operation  is  that  of  verification.  This 
procedure  is  about  the  same  as  that  required  for  the 
examination  of  a  check  brought  by  the  holder  to  the 
bank  for  cashing,  for  there  is  really  no  difference 
between  the  presentation  of  instrimients  directly  by 
the  holder  at  the  window  or  indirectly  through  the 
clearing  house.     If  the  check  meets  all  tests  satis- 


BANK   OPERATION  85 

factorily  it  is  then  sent  to  the  bookkeeper,  who  deducts 
the  amount  from  the  account  of  the  drawer  of  the 
check.  Not  all  banks  in  a  community  are  associated 
with  the  local  clearing  house,  and  checks  drawn  upon 
some  must  be  presented  by  messengers.  In  the  same 
way,  other  city  cash  items,  such  as  bills  of  exchange 
and  promissory  notes,  are  collected,  for  these  are  not 
necessarily  presented  to  a  bank,  but  may  also  be 
payable  at  the  business  address  of  the  acceptor  or 
maker.  The  messengers  may  be  employed  by  the 
bank  itself,  but  smaller  institutions  are  able  to  dispense 
with  the  cost  of  maintaining  this  force  where  the  local 
clearing  house  operates  a  department  for  collecting 
the  city  items  of  its  members.  In  New  York  City, 
the  Federal  Reserve  Bank  also  conducts  a  department 
which  presents  local  items  for  payment.  Thus  New 
York  banks  have  a  choice  of  three  systems  for  collecting 
their  city  items:  by  their  own  messengers,  and  by 
the  staff  of  either  the  clearing  house  or  the  Federal 
Reserve  Bank. 

VI.  Collection  of  Country  Items. 

Country  cash  items  are  credited  to  the  account  of  the 
depositors  at  once,  although  their  collection  and 
ultimate  payment  may  not  take  place  for  some  time, 
owing  to  the  fact  that  the  instruments  are  drawn  on 
banks  situated  outside  of  the  immediate  locality. 

These  instruments  are  handled  by  the  transit  de- 
partment. It  prepares  the  country  cash  it^ms  in 
much  the  same  manner  as  the  clearing-house  depart- 
ment handles  city  cash  exchanges— that  is,  by  indors- 
ing, sorting,  and  listing  them.  Transit,  or  country 
cash,  items  consist  mainly  of  checks  bearing  a  general 
indorsement  which  reads  somewhat  as  follows:  "Pay 
to  the  order  of  any  Bank,  Banker,  or  Trust  Company, 


86  BANKING  AND  BUSINESS 

all  prior  indorsements  guaranteed."  This  expression 
has  the  same  force  as  a  blank  indorsement,  for  it  en- 
ables any  collecting  bank  to  which  the  check  is  for- 
warded to  present  it  to  the  drawee  and  receive  pay- 
ment. By  this  indorsement  a  bank  is  able  to  transfer 
claims  with  far  greater  speed  than  by  a  special  indorse- 
ment which  stipulates  the  name  of  every  bank  acting 
as  collecting  agent.  The  indorsement  given  above  also 
includes  the  sending  bank's  ''transit"  number,  which 
is  composed  of  two  parts,  the  first  designating  the  local 
clearing  house,  the  city  or  the  state  to  which  the  bank 
belongs;  and  second,  the  clearing-house  number  of  the 
bank  itself.  For  example,  the  National  City  Bank  of 
New  York  is  numbered  1-8,  and  the  Continental  and 
Commercial  National  Bank  of  Chicago  is  designated 
as  2-3.  All  banks  throughout  the  country  are  Usted 
in  a  numerical  system  established  by  the  American 
Bankers'  Association,  and  the  out-of-town  items  are 
then  sorted  according  to  the  banks  which  are  to  act  as 
collecting  agents.  These  may  be  classified  either  on 
an  alphabetic  basis  according  to  the  name  of  the  col- 
lecting bank  or  on  a  geographic  plan,  depending 
upon  the  section  of  the  country  in  which  the  bank 
is  located. 

The  final  task  of  the  transit  department  is  to  list  or 
enter  the  details  concerning  the  outgoing  items  on  a 
letter  of  advice.  This  transit  letter  accompanies  the 
outgoing  checks  and  contains  such  information  as  the 
amount  of  the  items  inclosed,  the  name  or  transit 
number  of  the  payer,  and  any  special  instructions  to 
the  collecting  bank.  Country  cash  items  other  than 
checks  are  collected  in  about  the  same  manner.  As 
collection,  or  noncash,  items  are  not  credited  to  the 
customer's  account  until  actual  payment  has  been 
made,  this  handhng  involves  the  additional  task  of 


BANK  OPERATION  87 

holding  them  during  the  interval  between  their  deposit 
and  collection.  This  operation  must  be  performed 
with  accuracy,  for  failure  on  the  part  of  the  bank  to 
present  time  instruments  at  their  date  of  maturity 
may  bring  loss  to  the  holders  in  the  event  of  non- 
pa^Tiient. 

The  procedure  of  recording  and  filing  these  items 
until  their  maturity  is  described  as  ' 'timing. "  This 
operation  is  performed  by  recording  on  shps  or  "tick- 
ets" all  the  facts  necessary  for  negotiations,  such  as 
names  of  all  parties,  amount,  date,  and  place  of  pay- 
ment, together  with  any  special  instructions.  One 
ticket  is  usually  attached  to  the  instrmnent,  which  is 
then  placed  in  a  file,  and  the  entire  transaction  is 
entered  or  posted  in  a  record  book  called  a  ''tickler." 
Both  file  and  tickler  are  arranged  in  chronological 
order  so  that  the  items  can  readily  be  handled  as  they 
mature  from  day  to  day.  A  week  before  maturity  it  is 
customary  for  the  bank  to  send  to  the  maker  of  a  note 
or  the  acceptor  of  a  bill  a  notice  of  the  approaching 
maturity  of  the  obligation  and  of  the  necessity  of 
meeting  it  with  sufficient  funds. 

The  preparation  of  these  collection  items  in  a  small 
bank  devolves  upon  the  note  teller.  As  a  rule  it  is  his 
duty  to  receive  all  time  items  from  depositors  and  to 
prepare  these  instruments  for  collection.  In  the  evolu- 
tion of  bank  organization  the  note  teller  lost  most  of 
his  collection  duties  and  has  retained  only  the  operation 
of  receiving  time  items  across  the  window.  In  addi- 
tion, his  department  has  been  given  a  variety  of  other 
tasks,  so  that  it  is  regarded  as  the  internal  clearing 
house  for  handling  all  miscellaneous  items  which  arise 
in  the  daily  routine  of  the  bank.  The  preparation  of 
instruments  for  collection  is  performed  by  several  de- 
partments which  are  known  by  various  names,  but 


88  BANKING  AND  BUSINESS 

they  may  be  described  simply  as  city  and  country 
collection  departments.  In  brief,  their  duties  consist 
of  preparing  and  collecting  noncash  items.  The  work 
of  preparation  and  collection  is  about  the  same  as  in  the 
case  of  a  cash  item. 


VII.  Collection  of  Coupons. 

Discussion  so  far  has  been  confined  to  the  collection 
of  checks,  notes,  and  drafts,  but  it  should  be  remem- 
bered that  customers  deposit  also  coupons  which  the 
bank  must  present  for  payment.  They  may  be  classi- 
fied the  same  as  any  other  collection  items.  If  the 
coupons  have  already  matured  they  are  regarded  as 
cash  items,  and  if  still  unmatured  they  are  held  for  col- 
lection. Coupons  are  usually  payable  in  New  York 
City,  where  most  bond  issues  are  financed  and  where  the 
fiscal  agents  of  large  corporations  and  municipalities 
are  generally  located.  Coupons  are  collected  in  much 
the  same  manner  as  other  instruments,  but  as  they 
are  of  various  sizes  and  forms,  it  is  customary  to  place 
them  in  special  envelopes  in  which  all  necessary  data 
are  written  by  the  depositor.  Coupons  cut  from 
securities  other  than  those  issued  by  the  federal,  state, 
or  municipal  governments  must  be  accompanied  also  by 
a  certificate  of  ownership  required  under  the  federal 
income-tax  laws. 

In  summary,  the  purpose  of  any  collection  depart' 
ment  is  to  present  credit  instruments  for  acceptance 
or  for  pajTnent.  In  this  respect  there  is  no  essential 
difference  between  the  work  of  a  bank's  city-collection 
and  clearing-house  departments,  on  the  one  hand,  and 
between  the  country-collection  and  transit  divisions, 
on  the  other  hand.  The  city  and  country  collection 
departments,  in  handhng  noncash  items,  ha^^e  an  addi- 


BANK  OPERATION  89 

tional  duty  in  ''timing"  or  holding  these  items  in  the 
interval  between  their  deposit  and  actual  payment. 

VIII.  The  Credit  Department. 

A  depositor's  account  may  be  built  up  by  cash,  credit 

instruments,  or  by  loans.  The  disposition  of  the  cash 
by  the  paying  teller,  and  the  handling  of  credit  instru- 
ments by  the  collection  departments,  have  already 
been  considered,  and  it  now  remains  to  describe  the 
manner  in  which  the  bank  grants  loans  to  its  customers. 
This  method  depends  largely  upon  whether  the  loans 
are  secured  or  unsecured.  The  bank  may  insist  that 
the  borrower  pledge  some  form  of  property  as  security 
for  the  final  payment  of  his  obhgations,  or  it  may  waive 
any  collateral,  and  base  its  loan  to  the  customer  entirely 
on  the  general  ability  to  repay.  Before  extending  an 
unsecured  loan,  a  bank  must  first  assure  itself  of  the 
financial  standing  and  business  record  of  the  prospective 
borrower. 

The  collecting,  analyzing,  and  fihng  of  such  informa- 
tion are  performed  by  the  credit  department,  which  is 
often  divided  into  several  divisions,  each  specializmg 
in  a  particular  operation.  From  all  possible  sources 
the  investigation  division  gathers  information  regard- 
ing borrowers.  These  findings  are  assembled  and  pre- 
sented in  classified  credit  folders.  From  these  reports 
the  officers  determine  the  line  or  maximum  limit  of 
credit  to  be  ext-ended  by  the  bank  to  each  borrower. 
The  credit  folders  are  continually  handled  by  the  in- 
vestigation division,  which  adds  current  information, 
and  by  the  analysis  section,  which  as  a  result  revises 
credit  lines.  It  is,  therefore,  essential  to  maintain  a 
filing  system  which  can  furnish  (juick  und  convenient 
access  to  the  credit  records.  Another  di\ision  of  the 
credit  department  conducts  the  large  volume  of  corre- 


90  BANKING  AND   BUSINESS 

spondence  with  other  banks  and  business  houses  with 
wliich  credit  information  is  interchanged.  Another 
operation  of  the  credit  department  is  to  buy  notes  and 
acceptances  for  country  correspondent  banks  seeking 
to  invest  surplus  funds.  A  ''new  business"  division  is 
of  value  in  explaining  the  services  of  the  bank  to  pros- 
pective customers  and  thus  gaining  additional  accounts. 
Thus  a  complete  credit  department  includes  investiga- 
tion, analysis,  filing,  correspondence,  commercial  paper, 
and  new-business  divisions. 

IX.  Loan  and  Discount  Department. 

The  advances  which  a  bank  extends  to  its  customers 
are  described  either  as  loans  or  discounts.  The  dis- 
tinction lies  in  the  fact  that  in  the  case  of  the  former 
interest  is  collected  usually  at  maturity,  while  in  the 
latter  the  discount  is  deducted  in  advance.  As  a 
general  rule,  loans  are  coUateraled  by  some  form  of 
security,  while  discounts  are  usually  unsecured. 

As  there  is  little  uniformity  among  banks  in  the 
organization  of  their  lending  departments,  it  is  best 
to  omit  such  description,  and  instead  to  consider  the 
operation  of  handling  a  typical  demand  loan  and  a 
time  loan.  A  demand  loan  is  usually  accompanied  by 
collateral  which  may  consist  of  stocks  and  bonds.  The 
borrower  sends  these  securities  to  the  loan  department, 
where  they  are  carefully  examined,  and  their  value  is 
determined  by  reference  to  the  current  market  quota- 
tions. The  bank  usually  insists  upon  a  margin  or 
difference  of  about  20  per  cent  of  excess  value  in  the 
amount  of  security  over  the  amount  of  the  loan.  The 
purpose  of  this  margin  is  to  safeguard  the  bank  against 
loss  if  the  market  value  of  the  collateral  declines. 

A  margin  alone  is  not  sufficient  to  protect  the  bank, 
for  the  collateral  must  also  be  satisfactory  in  character. 


BANK  OPERATION  91 

A  bank  seeks  to  distribute  its  risk  by  demanding  mixed 
collateral  consisting  of  railroad,  industrial,  and  other 
securities,  rather  than  straight,  which  is  composed 
only  of  one  class.  Conservative  stocks  are  preferred 
to  speculative,  which  are  of  an  uncertain  value.  An 
active  security  is  favored  over  an  inactive  one,  for  the 
bank  can  more  readily  find  a  buyer  if  the  loan  is  unpaid. 
In  order  to  give  the  bank  full  title  to  the  securities  they 
must  have  good  delivery — that  is,  be  negotiable  in 
form — and  so  they  are  either  indorsed  in  blank  by  the 
borrower  or  he  signs  a  power  of  attorney.  If  the  collat- 
eral is  acceptable  as  to  value,  margin,  quality,  and 
delivery,  the  bank  receives  a  demand  note  signed  by 
the  borrower  and  in  return  grants  him  the  loan. 

The  procedure  of  handling  a  time  loan  includes  the 
keeping  of  several  additional  records.  All  facts  relat- 
ing to  the  promissory  note  are  first  entered  in  a  dis- 
count ledger,  which  gives  the  complete  history  of  the 
debt  between  borrower  and  bank.  As  the  note  is  a 
time  obligation,  it  is  entered  in  a  maturity  tickler, 
which  is  a  diary  of  all  loans  filled  chronologically 
according  to  their  due  dates.  The  name  of  the  maker 
and  all  the  indorsers  are  recorded  in  a  book  known  as  a 
liability  ledger.  The  bank  thus  knows  the  direct  and 
the  contingent  liabilities  of  each  borrower  and  is  able  to 
prevent  overextension  of  credit  to  any  individual  or 
firm.  On  the  maturity  date  the  note  is  presented  to 
the  maker,  and  if  payment  is  made  the  obligation  is 
canceled. 

X.  Bookkeeping  Department. 

In  considering  the  operation  of  the  various  depart- 
ments, reference  has  been  made  to  the  use  of  ticklers 
for  making  temporary  entries  of  daily  transactions  and 
also  registers  for  posting  more  permanent  data.    These 


92  BANKING  AND  BUSINESS 

books  may  be  either  bound  or  loose-leaf  in  form. 
The  bound  book  is  a  more  enduring  record  and  less 
subject  to  alteration,  but  it  is  not  so  flexible  as  the 
loose-leaf  folder,  which  can  be  expanded  by  additional 
carbon  slips  or  tickets.  The  latter  style  of  accounting, 
together  with  the  "block  proof"  for  segregating  errors, 
is  being  extensively  adopted  by  American  banks. 

Whenever  the  records  of  the  departments  affect 
the  accounts  of  customers,  corresponding  entries  are 
made  in  the  individual  ledgers,  which  are  divided 
according  to  the  several  classes  of  depositors,  including 
individuals,  banks,  and  governments.  If  accounts  be- 
come numerous,  they  cannot  all  be  entered  in  one  book 
and  so  are  further  divided  into  ledgers  corresponding 
to  groups  of  the  alphabet,  as  A-F,  G-M,  and  0-Z. 
Under  the  name  of  each  customer,  entry  is  made  of  all 
credits  to  his  account  from  his  deposit  sUps  and  all 
debits  resulting  from  his  checks. 

The  records  of  the  departments  are  also  transposed 
into  accounts  grouped  according  to  the  class  of  trans- 
actions. These  accounts  summarize  the  transactions 
of  the  bank  and  constitute  the  general  ledger.  Thus 
every  bank  has  an  individual  bookkeeper  who  enters 
the  separate  dealings  with  customers,  and  a  general 
bookkeeper  who  assembles  the  complete  records  of  the 
bank. 

A  large  bank  maintains  an  auditor's  department  to 
verify  records  and  to  improve  the  systems  of  keeping 
books.  Some  departments  of  the  bank  are  audited 
only  at  various  times  throughout  the  year,  while  others 
handling  cash  or  securities  are  under  continuous 
scrutiny.  In  addition  to  examining  the  records  of 
the  departments,  the  auditor's  staff  reconciles  dif- 
ferences in  the  accounts  of  depositors  and  prepares  the 
bank's  reports  to  the  government  and  to  directors.  It 
is  essential  to  allow  complete  freedom  of  action  to  the 


BANK  OPERATION  93 

auditor's  department,  so  it  is  independent  of  the 
administrative  officers  of  the  bank  and  is  accountable 
only  to  the  board  of  directors. 

XI.  Service  Departments. 

In  addition  to  the  general  operation  departments  for 
handling  deposits,  collecting  items,  and  making  loans, 
a  bank  also  conducts  a  service  department  consisting  of 
a  number  of  internal  and  external  divisions.  The  in- 
ternal, or  house,  service  divisions  are  auxiliary  aids  in 
the  efficient  administration  of  the  bank,  and  their 
number  will  vary  with  the  size  of  the  bank.  A  large 
institution  may  operate  the  folloA\ing  divisions:  (1)  em- 
ployment   (interviews   and  engages   new  employees), 

(2)  medical  (examines  applicants  for  positions  in  the 
bank    and    gives    medical    attention    to    employees), 

(3)  educational  (directs  courses  for  special  training  in 
banking  practice  or  for  general  studies  in  language 
or  current  economic  events),  (4)  welfare  (conducts 
recreation  activities  for  employees),  (5)  library  (main- 
tains a  circulating  and  reference  library),  (6)  purchas- 
ing (buys  supplies  and  distributes  them  thoroughout  the 
bank),  (7)  stenographic  (performs  addressograph,  multi- 
graph,  and  typing  work).  For  the  benefit  of  customers 
a  bank  may  conduct  external  service  departments  as 
the  following:  (1)  industrial  (gives  advice  on  problems 
of  industrial  management  such  as  cost  systems, 
purchasing,  production,  and  sales  methods,  insurance 
taxation,  and  advertising) ;  (2)  foreign  trade  (furnishes 
economic  and  statistical  information  on  foreign  market 
conditions,  shipping  methods,  and  tariffs);  (3)  pub- 
licity (issues  news  lett-ers  on  general  financial  conditions, 
pamphlets  on  special  subjects,  such  as  trade  oppor- 
tunities or  investments,  booklets  on  facilities  offered 
by  the  bank,  and  press  notices) ;   (4)  trading  (executes 


94  BANKING  AND   BUSINESS 

orders  to  buy  and  sell  securities  on  the  market) ;  (5)  in- 
vestments (recommends  securities  for  investment); 
(6)  taxation  (computes  state  and  federal  taxes  on 
incomes,  excess  profits,  issues  of  bonds,  and  transfers  of 
stocks). 


CHAPTER  VII 

THE   DEPOSITOR   AND   HIS   BANK 

Deposits  in  the  broad  meaning  are  created  from: 
(1)  actual  cash,  (2)  credit  instruments  left  by  custo- 
mers, and  (3)  credit  extended  by  the  bank  itself. 
Discussion  of  the  third  type  will  be  deferred  until  the 
folloA\ing  chapter,  while,  for  the  present,  attention  is 
directed  to  the  subject  of  deposits  in  the  sense  of 
actual  property  or  titles  to  property  left  with  the  bank 
by  its  customers.  Such  deposits  constitute  the  very 
foundation  on  which  a  bank  is  able  to  erect  its  structure 
of  credit,  for  without  sufficient  deposits  of  cash  or  cash 
items  it  would  be  impossible  to  grant  loans  to  bor- 
rowers. From  this  vie^^^Doint  of  deposits,  the  chapter 
will  consider  their  classification,  the  relation  between 
bank  and  depositor,  the  opening  of  accounts,  induce- 
ments offered  to  secure  new  customers,  and  the  payment 
of  interest  on  deposits. 

I.  Classes  of  Deposits. 

1.  Special  Deposits. 

Deposits  from  the  standpoint  of  the  bank  may  be 
classified  either  as  special  or  general.  The  legal  nature 
of  a  special  deposit  is  quite  similar  to  that  of  cotton 
or  any  other  commodity  stored  in  a  warehouse.  The 
warehouseman  is  expected  to  maintain  the  goods 
securely  and  deliver  them  intact  to  the  owner  at  his 
request.  In  the  same  way,  the  banker  is  intrusted 
with  money,  jewelry,  or  other  valuables  which  must  be 


96  BANKING  AND  BUSINESS 

kept  in  &  safe  place  and  returned  to  the  depositor  when- 
ever he  calls  for  them.  He  has  a  right  to  demand  the 
identical  deposit,  for  he  always  retains  title  to  it.  The 
bank  is  in  no  case  the  owner  of  a  special  deposit,  but 
is  only  the  trustee.  In  this  capacity  the  bank  is 
expected  to  exercise  reasonable  care  in  safeguarding 
special  deposits  and  to  provide  the  same  protection 
as  for  its  own  property. 

2.  General  Deposits. 

A  general  deposit  differs  from  the  special  in  respect 
to  composition,  title,  and  liability.  A  general  deposit 
consists  largely  of  cash  or  cash  items  which  include 
checks,  notes,  drafts,  or  coupons.  The  actual  owner- 
ship passes  immediately  from  the  depositor  to  the 
bank,  which  does  not  segregate  each  deposit,  but 
combines  them  indiscriminately.  In  exchange  for  his 
deposit,  the  customer  receives  a  claim  in  his  favor  on 
the  books  of  the  bank,  which  then  assumes  the  position 
of  a  debtor.  The  depositor,  as  creditor,  has  the  right 
to  demand  payment  for  all  or  part  of  the  amount  left 
with  the  bank,  which  in  turn  is  bound  to  refund  this 
sum  from  its  general  assets. 

General  deposits  are  payable  either  on  demand  or 
after  a  certain  period  of  time.  Demand  deposits  may 
be  withdrawn  immediately  from  the  bank  by  means  of 
checks,  while  time  deposits  are  payable  only  after  a 
lapse  of  a  certain  number  of  days.  Sums  left  with 
savings  institutions  are  really  time  deposits,  for  the 
banks  may  in  an  emergency  insist  upon  a  notice  of 
thirty  to  sixty  daj'^s  from  depositors  who  wish  a  refund 
of  their  money.  Commercial  or  business  banks  handle 
mainly  demand  accounts,  but  receive  also  time  or 
savings  deposits  which  are  payable  only  after  notice, 
usually  of  thirty  days,  has  been  filed  by  the  customer. 
As  the  bank  is  thus  relieved  of  the  necessity  of  effecting 


THE   DEPOSITOR  AND   HIS   BANK    97 

payment  at  sight,  it  is  able  to  invest  these  funds  in 
slower  assets.  Besides,  a  bank  which  is  a  member  of 
the  Federal  Reserve  system  derives  a  further  ad- 
vantage from  deposits  which  can  be  ^\^thdrawn  only 
after  thirty  days'  notice,  since  these  require  the  mainte- 
nance of  a  lower  percentage  of  legal  reserve  than  against 
demand  deposits.  The  bank  is,  therefore,  solicitous  of 
securing  time  deposits,  and  so  as  an  inducement  offers 
its  customers  a  rate  of  interest  higher  than  that  paid 
on  demand  deposits. 

3.  Certificates  of  Deposit. 

General  deposits  are  recorded  by  entries  in  a  pass 
book,  or  evidenced  by  certificates  of  deposit.  These 
are  instruments  in  which  a  bank  acknowledges  that  it 
has  received  a  sum  of  money  from  an  individual  and 
promises  that  the  amount  will  be  repaid.  The  cer- 
tificate of  deposit  thus  is  both  a  receipt  and  a  promis- 
sory note.  It  maj^  be  either  negotiable  or  nonnegoti- 
able  in  form.  If  negotiable,  it  is  payable  to  the  bearer 
or  to  the  order  of  a  designated  party,  who  may  transfer 
it  by  indorsement,  as  in  the  case  of  any  other  negoti- 
able instrument.  A  certificate  of  deposit  payable 
directly  to  a  specified  party  is  nonnegotiable,  and  may 
be  assigned  to  another  person  only  by  changing  the 
entries  on  the  books  of  the  bank.  The  certificate  of 
deposit  is  payable  either  on  demand  or  on  time.  The 
demand  certificate  is  used  as  an  instrument  for  guaran- 
teeing the  cash  payment  of  obligations  or  for  the  trans- 
ferring of  funds  from  one  place  to  another,  and  there- 
fore serves  the  same  purpose  either  as  a  ceitified  check 
or  a  bank  draft.  Consequently  the  demand  certificate 
must  be  negotiable,  so  that  it  can  readily  be  transferred 
by  the  depositor  to  his  creditor.  This  party  to  the  trans- 
action is  usually  prompt  in  cashing  the  instrument, 
as  it  is  generally  noninterest  bearing.     As  time  certifi- 


98  BANKING  AND  BUSINESS 

cates  of  deposit,  on  the  other  hand,  are  nonnegotiable, 
they  yield  a  reasonable  rate  of  interest  and  thus  offer 
profitable  means  of  investing  funds  which  would 
otherwise  remain  idle.  Time  certificates  are  payable 
at  either  a  definite  or  an  indefinite  date  of  maturity. 
One  class  matures  on  a  set  date,  while  the  other  is 
payable  thirty  days  after  any  date  on  which  the  holder 
has  filed  notice  of  his  intention  to  withdraw  his  deposit. 
In  general,  certificates  of  deposit  differ  from  ordinary 
deposits  in  that  the  amount  of  the  former  remains  un- 
changed, for  it  can  neither  be  increased  by  deposits  of 
additional  sums,  nor  decreased  by  withdrawals  through 
checks. 

The  various  forms  of  deposits  may  be  summarized 
as  follows: 

I  special 

\  general  f  demand 

[  passbook  1  time 

j  f  demand 

[  certificate  of  deposit  [  time 

II.  Classes  of  Depositors. 

Viewed  from  the  standpoint  of  origin,  the  deposits 
of  a  commercial  bank  may  be  grouped  as  pubhc  or 
private.  The  United  States  government  maintains  ac- 
counts with  many  of  the  large  national  banks  through- 
out the  country,  and  likewise  states  and  municipalities 
deposit  their  funds  in  local  institutions.  Banks  are 
always  desirous  of  receiving  these  funds,  because  of  the 
added  confidence  of  the  community  in  depositories  of 
government  moneys.  These  balances  in  themselves 
are  especially  valuable,  as  they  are  not  generally  sub- 
ject to  unexpected  withdrawals  and  so  remain  rela- 
tively constant  in  amount.  Public  deposits  are  created 
either  from  receipts  of  taxes,  customs  duties,  and  other 
revenues,   or  from  loans   by  banks   to   governments 


THE   DEPOSITOR  AND   HIS   BANK    99 

through  the  purchase  of  bonds,  certificates  of  indebted- 
ness, and  other  pubUc  securities.  However,  the  bulk 
of  bank  deposits  are  derived  not  from  pubhc,  but 
private  sources.  In  the  United  States  the  system  of 
making  payments  through  checks  has  developed  so 
extensively  that  even  persons  of  moderate  means  carry 
bank  accounts  for  handling  their  domestic  disburse- 
ments. A  banking  connection  is  essential  to  the  small 
business  man  as  well  as  to  the  large  firm.  The  ac- 
counts of  persons,  partnerships,  and  corporations  are 
all  grouped  together  as  individual  deposits,  to  dis- 
tinguish them  from  balances  left  with  a  bank  by  other 
banks.  Country  banks  maintain  accounts  with  corre- 
spondents in  the  large  cities  in  order  to  draw  drafts 
against  these  funds  and  sell  them  to  local  customers 
who  wish  to  remit  funds  to  New  York,  Chicago,  Bos- 
ton, and  other  business  centers.  Because  of  the 
inability  at  times  to  find  suitable  placement  at  home, 
country  banks  are  forced  to  send  their  surpluses  to 
metropolitan  correspondents,  which  may  lend  them 
on  the  open  money  market  and  are  thus  able  to  allow 
interest.  Banks  also  maintain  reciprocal  balances  to 
facilitate  the  collection  of  items  dra^^Tl  by  their  cus- 
tomers on  banks  or  business  houses  in  other  cities. 

Deposits  are  also  made  by  trustees  acting  in  such 
capacities  as  guardians  of  minors  and  executors  of 
estates.  The  funds  are  left  with  the  bank  until  suit- 
able opportunity  for  investment  arises  or  final  settle- 
ment of  an  estate  is  effected  Thus  private  deposits 
may  be  classified  as  individual,  bank,  and  fiduciary. 

Accounts  differ  somewhat  as  to  the  method  in  which 
each  is  opened.  A  bank  will  accept  a  new  fiduciary 
account  only  if  the  trustee  can  show  an  order  from  the 
court  appointing  him  as  guardian,  executor,  receiver, 
or  in  some  other  fiduciary  capacity.  When  a  corpora- 
tion opens  a  new  account  it  is  necessary  for  the  organ- 


100  BANKING   AND   BUSINESS 

ization  to  submit  a  certified  copy  of  the  by-laws  or 
resolutions  authorizing  the  deposit  of  funds  and  em- 
powering an  officer  such  as  the  treasurer  to  draw 
checks  against  these  deposits.  A  bank  usually  insists 
upon  identification  before  accepting  a  new  account  from 
an  individual.  He  may  bring  written  references  or  be 
personally  introduced  by  another  depositor  of  the 
bank.  These  precautions  must  be  taken  by  the  bank, 
for  it  assumes  a  certain  amount  of  risk  in  giving  a 
checking  account  to  a  stranger,  who  may  use  it  to 
perpetrate  a  fraud.  If  the  credentials  of  the  applicant 
are  unsatisfactory,  the  bank  will  deny  his  request  for 
an  account.  In  fact,  the  bank  has  a  right  either  to 
refuse  or  later  to  close  an  account  at  any  time,  if 
such  step  is  warranted  by  the  actions  of  the  depositor. 
However,  a  new  account  is  seldom  rejected,  and  the 
applicant  soon  finds  himself  an  accepted  depositor  of 
the  bank  after  complying  with  certain  formalities. 
The  applicant  for  an  account  fills  out  a  card  supplying 
information  concerning  his  business,  a  statement 
agreeing  to  observe  the  bank's  regulations,  and  a 
blank  giving  a  specimen  of  his  signature. 

III.  Methods  of  Securing  New  Accounts. 

Deposits  are  essential  to  the  continued  existence 
of  any  bank,  and  so  there  is  keen  competition  to  retain 
old  accounts  and  to  secure  new  ones.  Banks  formerly 
regarded  the  soliciting  of  deposits  as  an  unprofessional 
procedure,  but  this  attitude  has  been  abandoned  and 
now  aggressive  publicity  methods  are  used  to  secure 
new  business.  Banks  advertise  extensively  in  news- 
papers and  magazines,  and  bring  themselves  to  the 
attention  of  the  public  through  notices  in  street  cars 
and  even  on  billboards.  A  more  direct,  personal  con- 
tact may  be  secured  with  actual  or  potential  depositors 


THE   DEPOSITOR  AND   HIS   BANK  lOi 

by  mailing  them  letters,  booklets,  circulars,  and  other 
literature. 

A  bank  is  thus  able  to  set  forth  the  various  services 
which  it  can  render  to  the  business  man.  It  aids  him 
in  receiving  his  valuables  for  safe  keeping,  in  allowing 
him  interest  on  his  surplus  funds  and  in  accepting  his 
deposits,  against  which  he  may  draw  checks  to  pay  his 
obligations.  The  bank  also  collects  for  its  customers 
checks,  notes,  and  acceptances  given  by  their  debtors, 
and  secures  payment  of  these  instruments.  The  un- 
derlying service  which  a  bank  performs  for  its  clients 
is  to  grant  them  loans  for  the  conduct  of  their  business. 
Herein  lies  the  advantage  to  a  business  man  of  associat- 
ing himself  with  a  strong  bank,  for  it  will  naturally  give 
preference  to  its  regular  customers  in  time  of  a  stringent 
money  market,  when  careful  discrimination  among 
applicants  for  loans  is  necessary.  The  maintenance 
of  an  account  with  an  established  banking  institution 
in  itself  adds  to  the  credit  standing  of  the  client  and 
thus  increases  his  capacity  to  borrow  funds  from  the 
community. 

In  addition  to  these  services  which  lie  strictly  in  the 
field  of  banking,  various  subsidiary  accommodations 
are  offered  in  order  to  secure  new  accounts.  Service 
departments  aid  customers  by  furnishing  them  informa- 
tion on  industrial  management,  foreign  trade,  invest- 
ments, and  taxation. 

IV.  Payment  of  Interest  on  Deposits. 

A  wide  difference  of  opinion  exists  as  to  payment  of 
interest  on  balances  as  a  means  of  attracting  deposits. 
This  problem  may  best  be  understood  l)}^  viewing  it 
in  connection  with  the  various  classes  of  deposits  and 
depositors  of  the  commercial  bank.  The  question  of 
paying  interest  does  not  relate  to  sums  left  with  the 


102  BANKING  AND  BUSINESS 

bank  as  time  accounts  or  certificates  of  deposit,  for 
obviously  the  sole  reason  for  their  existence  is  the  fact 
that  they  yield  interest  to  the  depositors.  So  the 
question  is  confined  to  whether  a  bank  should  pay 
interest  on  demand  deposits.  In  normal  times  govern- 
ments rarely  seek  loan  accommodations  from  banks, 
nor  do  they  make  sudden  withdrawals  of  their  de- 
posits. Public  accounts,  therefore,  represent  deposits 
of  cash  which  remain  relatively  inactive,  and  on  such 
deposits  banks  are  willing  to  pay  interest.  The  same 
may  be  said  of  fiduciary  accounts.  There  is  also  little 
objection  to  allowing  interest  on  balances  of  country 
banks,  for  these  institutions  at  the  same  time  bring 
profitable  business  to  their  city  correspondents. 

The  problem  whether  a  bank  shall  pay  interest, 
therefore,  refers  only  to  the  general  individual  demand 
deposits.  It  is  argued  that  these  funds  enable  banks 
to  operate  their  business,  and  therefore  depositors  are 
entitled  to  participate  in  profits.  This  contention  pos- 
sessed some  force  during  the  period  from  1914  to  1920, 
when  banks  reaped  large  earnings  and  were  able  to 
declare  high  dividends  on  their  stock.  However,  this 
prosperity  was  also  shared  by  other  lines  of  business, 
and  these  firms  would  scarcely  be  expected  to  share 
profits  with  their  customers. 

Another  argument  in  favor  of  paying  interest  on 
individual  deposits  arises  by  analogy  from  the  fact 
that  such  concessions  are  granted  on  other  kinds  of 
deposits.  It  must  be  remembered  that  there  is  a  special 
reason  for  allowing  interest  on  each  of  these  balances 
as  indicated  above.  Also  it  is  maintained  that  British 
and  continental  banks  pay  interest  on  their  deposits. 
However,  one  must  be  mindful  of  the  fact  that  Euro- 
pean monetary  and  banking  conditions  differ  consider- 
ably from  those  which  exist  in  the  United  States.  In 
most  European  countries  the  fundamental  medium  of 


THE   DEPOSITOR  AND   HIS   BANK  lo;; 

exchange  is  the  circulating  bank  note,  while  here  the 
leading  instrument  for  making  payment  is  a  check 
drawn  against  a  bank  deposit.  An  account  with  an 
American  bank  is  largely  the  result  of  credit  extended 
to  the  customer  by  the  bank  itself,  while  a  deposit  in  a 
European  bank  more  frequently  results  from  the 
leaving  of  actual  cash. 

Replying  to  the  arguments  favoring  the  payment  of 
interest  on  deposits,  it  is  held  that  in  general  this  step 
would  lead  banks  to  adopt  unsafe  policies.  It  is  an 
axiom  of  business  that  the  amount  of  profit  varies 
directly  with  the  element  of  risk.  If  the  necessity  of 
granting  interest  on  deposits  forces  a  bank  to  strive 
for  higher  rates  on  its  loans,  obviously  the  possibility  of 
losses  will  be  increased.  Also  a  bank  would  be  com- 
pelled to  keep  all  its  funds  continually  on  an  active 
earning  basis,  and  would  be  thus  unable  to  retain  any 
considerable  part  as  a  reserve  to  meet  a  sudden  demand 
of  its  depositors  for  payment. 

V.  Rate  of  Interest  on  Deposits. 

There  is  no  settled  practice  among  American  banks 
regarding  the  payment  of  interest  on  individual  demand 
deposits.  Unless  the  bank  and  the  depositor  enter 
into  a  special  agreement,  a  demand  deposit,  by  implica- 
tion, draws  no  interest.  An  analysis  of  this  subject 
in  New  York  State  in  1918  disclosed  the  fact  that  most 
commercial  banks  and  trust  companies  allowed  no 
interest  on  checking  accounts.  In  many  sections  of  the 
country  where  there  is  keen  competition  among  local 
banks,  they  frequently  grant  such  allowances  as  in- 
ducements to  win  new  deposits  or  to  maintain  old 
accounts.  Banks  often  find  it  necessary  to  grant 
interest  to  depositors  who  might  otherwise  keep  their 

balances  down  to  a  minimum  sufficient  only  for  their 

8  ^ 


104  BANKING  AND  BUSINESS 

checking  needs.  Rates  as  high  as  5  per  cent  have  been 
offered,  with  the  result  that  institutions  have  at  times 
been  finally  forced  into  insolvency.  In  order  to  re- 
strain such  unwholesome  competition,  clearing-house 
associations  have  frequently  established  regulations 
limiting  the  maximum  rate  which  member  banks 
are  permitted  to  grant  on  checking  accounts.  This 
rate  usually  varies  from  2  to  234  per  cent  per  annum. 
In  fact,  the  rate  should  not  be  constant  in  amount, 
but  rather  should  vary  with  the  condition  of  the  money 
market.  As  the  discount  rate  rises  and  falls,  a  con- 
sequent adjustment  should  be  made  in  the  interest 
allowed  on  bank  deposits. 

Where  interest  is  allowed  the  method  of  computa- 
tion depends  upon  such  factors  as  time,  balance,  and 
rate.  Interest  may  be  allowed  over  a  period  of  time 
covering  half  or  quarter  of  a  year,  but  it  is  more  cus- 
tomary to  reckon  on  the  balance  deposited  within  a 
month.  The  balance  thus  used  as  a  basis  for  compu- 
tation may  be  the  lowest  amount  which  has  been 
credited  to  the  customer's  account  on  any  one  day 
within  the  month.  This  plan  is  rather  inequitable 
from  the  viewpoint  of  the  depositor,  who  may  have 
allowed  his  account  to  run  low  on  this  particular  day 
because  of  heavy  disbursements.  A  more  satisfactory 
basis  of  reckoning  is  the  average  daily  amount  main- 
tained within  the  month.  The  more  exact  method  is  to 
calculate  interest  on  the  customer's  balances  separately 
for  each  day  of  the  month.  As  checking  accounts  are 
quite  active  and  are  continually  changing  in  amount, 
interest  computation  is  no  little  task  for  the  book- 
keeping department.  An  added  difficulty  is  encoun- 
tered because  interest  cannot  be  calculated  merely  on 
the  gross  balance  credited  to  the  customer  on  the  books 
of  the  bank.  This  amount  cannot  be  regarded  as  the 
customer's  net  cash  deposits,  for  it  includes  all  checks, 


THE   DEPOSITOR  AND   HIS  BANK  105 

drafts,  and  other  items  which  have  been  credited  but 
are  still  uncollected  and  so  are  not  yet  available  to  the 
bank  for  the  purpose  of  making  loans.  The  true 
interest  balance  for  any  day  may  be  expressed  in  a 
formula  which  reads  as  follows:  interest  balance  =  net 
cash  balance  at  the  opening  of  the  day  +  net  cash 
and  cash  it«m  deposits  credited  to  the  account— check- 
ings and  other  withdrawals  debited  during  the  day. 

The  rate  allowed  on  a  balance  is  fixed  by  special 
agreement  between  depositor  and  bank,  but  it  usually 
depends  upon  such  factors  as  amount,  activity,  and 
composition  of  balance.  A  large  city  bank  seldom 
grants  interest  on  balances  which  fall  below  an  average 
daily  amount  of  one  thousand  dollars,  for  the  overhead 
cost  of  a  small  account  is  about  the  same  as  of  a  large 
balance.  An  account  which  remains  dormant  may 
command  an  interest  allowance,  while  little  can  be 
granted  by  a  bank  on  an  active  balance  against  which 
checks  are  continually  drawn.  A  bank  must  also 
consider  the  relative  proportion  of  cash  in  an  account 
as  compared  with  the  amount  derived  from  loans 
granted  to  the  customer. 


CHAPTER  VIII 

FINANCING   THE   BUSINESS   MAN 

I.  Problems  in  Financing  Business  Enterprises. 

As  already  seen,  the  relationships  between  the  public 
and  the  banker  may  be  merely  those  of  depositor  and 
safe  keeper,  or  of  purchaser  and  furnisher  of  remittance 
or  exchange,  or  of  user  and  supplier  of  currency.  In 
addition  to  these  there  is,  as  already  mentioned, 
another  relationship,  which  is  that  of  lender  and  bor- 
rower. It  is  this  relationship  which  gives  oppor- 
tunity for  the  exercise  of  the  real  service  of  the  bank, 
since  it  gives  opportunity  for  the  institution  to  perform 
the  function  known  as  extension  of  credit.  This 
function  results  in  the  creation  of  what  are  called  loans 
and  discounts  on  the  part  of  the  bank  and  these  loans 
and  discounts  are  paralleled  or  represented  on  the 
ledger  by  "deposit  liabilities."  The  loans  and  dis- 
counts assume  any  one  of  a  number  of  different  forms, 
according  to  the  type  of  "paper"  which  the  bank  has 
bought  or  discounted. 

It  must  not  be  supposed,  however,  that  the  bank 
can  purchase  any  kind  of  paper  it  chooses  or  can  select 
the  constituent  elements  in  its  portfolio  according  to 
its  own  disposition.  The  bank  is  surrounded  by  a 
community  which  has  specified  habits  and  customs  of 
doing  business.  These  cannot  be  immediately  al- 
tered as  a  result  of  request  or  dictation,  but  if  modified 
must  be  changed  slowly  and   conservatively.     Even 


FINANCING   THE   BUSINESS  MAN   107 

within  a  given  community  the  individual  bank  finds 
it  a  difficult  problem  of  business  competition  to  select 
exactly  the  clientele  that  it  wants.  There  are  many 
kinds  of  borrowers  and  many  classes  of  business  in 
every  community.  In  every  trade,  occupation,  or 
profession  there  are  many  individuals  who  vary  in  their 
solvency  and  the  degree  of  their  reliability,  so  that  the 
bank  must  always  exercise  a  great  deal  of  discrimina- 
tion in  the  choice  of  its  loans,  while  it  finds  itself 
compelled  to  transact  within  certain  hmits  the  business 
that  comes  to  it,  since  it  cannot  afford  to  stand  aside 
merely  because  of  inability  to  get  the  particular  kind  of 
paper  which  its  officers  prefer.  There  is  thus  opened  in 
banking  a  serious  question — the  question  of  ascertaining 
the  conditions  in  business  which  practically  dictate 
or  control  the  kind  of  paper  that  can  be  offered  by  the 
business  man  in  return  for  the  advances  which  he 
asks,  and  the  further  question  of  giving  sound  advice 
to  the  borrower  with  respect  to  the  best  methods  to  be 
pursued  by  him  in  conducting  his  business,  regulating 
the  amount  of  his  loans,  and  determining  the  circum- 
stances under  which  he  will  trade.  The  field  of  study 
and  investigation  thus  opened  is  highly  varied  and  the 
issues  raised  are  multifarious.  Nevertheless,  it  is  pos- 
sible to  set  forth  in  a  general  way  the  problems  which 
present  themselves  to  the  banker  and  the  business  man 
in  financing  the  operations  of  any  particular  enter- 
prise. 

As  already  intimated,  the  fundamental  consideration 
to  be  borne  in  mind  in  determining  the  advances  to  be 
made  in  any  given  case  is  the  financial  and  commercial 
situation  in  the  trade  or  occupation  where  the  loans  are 
to  be  made.  Possibly  the  basic  element  in  this  kind 
of  study  is  the  ascertainment  of  the  credit  period  that 
is  customary  in  the  business.  Practically  every  trade 
or  occupation  has  what  are  called  "terms  of  sale"  or 


108  BANKING  AND  BUSINESS 

standard  terms.  By  this  is  meant  that  there  is  a  cus- 
tom or  unwritten  law  in  practically  every  trade  that 
an  ordinary  buyer  who  purchases  goods  from  a  seller 
shall  have  a  given  length  of  time  in  which  to  pay  for 
them.  In  this  country  at  the  present  time  such  terms 
are  frequently  thirty,  sixty,  or  ninety  days.  In  retail 
trade  the  usual  practice  may  be  to  sell  steadily  to  cus- 
tomers throughout  the  month,  with  the  understanding 
that  anything  bought  on  or  after  the  first  of  the  month 
is  to  be  billed  to  the  customer  on  the  first  of  the  follow- 
ing month,  with  the  expectation  that  remittance  will 
follow  within  a  reasonable  time  thereafter.  In  some 
agricultural  regions  where  customers  are  tenant  farmers 
who  have  little  available  money,  it  may  be  the  practice 
to  supply  goods  to  such  customers  steadily  throughout 
the  crop-raising  season,  so  that  the  period  of  credit 
there  will  be  from  four  to  six  months  and  in  some  cases 
longer. 

The  question  of  these  terms  of  sale  becomes  much 
more  complex  in  the  more  highly  developed  trades,  as 
well  as  in  relations  between  wholesalers  and  retailers. 
In  these  there  is  usually  a  series  of  alternative  terms. 
For  example,  if  a  bill  of  goods  is  invoiced  at  $100  it 
may  be  accompanied  by  a  printed  statement  to  the 
effect  that  cash  within  ten  days  will  result  in  a  reduc- 
tion of  2  per  cent,  cash  within  thirty  days  a  reduction 
of  1  per  cent,  while  the  customer,  if  he  allows  his 
account  to  run  for  sixty  days,  must  settle  at  full  face 
value.  The  details  of  these  terms  of  settlement  might 
be  multiplied,  but  would  add  nothing  to  the  general 
consideration  just  advanced,  which  is  that  the  terms  of 
credit  prevailing  in  any  particular  industry  determine 
approximately  the  length  of  time  for  which  the  business 
man  must  extend  credit  to  his  customer,  or  in  ordinary 
language  must  "carry"  the  latter.  If  a  banker  has  a 
clientele  consisting  of  wholesalers  who  in  the  spring  of 


FINANCING  THE  BUSINESS  MAN  109 

the  year  sell  their  goods  to  customers  on  a  credit  which, 
as  experience  has  shown  in  the  past,  is  Ukely  to  run 
about  sixty  days,  this  means  that  the  bank,  in  order 
to  be  of  service,  must  stand  ready  to  extend  sixty  days 
of  credit  to  its  customers  in  order  to  give  them  hnme- 
diate  use  of  the  funds  which  they  need  in  order  to  get 
the  proceeds  of  goods  which  they  have  sold  to  cus- 
tomers. It  is,  of  course,  true  that  the  bank  can  in 
individual  cases  encourage  its  customers  to  shorten 
their  period  of  credit  by  various  methods  to  which 
reference  will  later  be  made.  But  looking  at  the  bank 
not  as  an  individual  institution,  but  as  an  aggregate 
of  institutions  bearing  a  certain  relationship  to  the 
borrowers  or  customers  as  a  group,  it  is  clear  that  the 
bank's  average  term  of  credit  must,  if  desired,  be 
allowed  to  run  up  to  the  average  term  of  credit  of  the 
commercial  conmiunity  or  must  correspond  roughly 
with  it. 

II.  Methods  of  Settlement. 

In  another  important  way  the  practices  of  the 
business  conmiunity  establish  a  foundation  for,  or 
limit  to,  those  of  the  bank.  This  is  seen  in  connec- 
tion with  the  kind  of  settlement  which  is  habitual  be- 
tween individuals.  For  histance,  if  it  is  customary, 
when  A  sells  goods  to  B,  for  B  to  give  A  a  promissory 
note,  then  it  is  evident  that  A's  bank  may  expect  to 
have  a  great  many  promissory  notes  of  customers 
presented  to  it  for  discount,  and  will  be  in  position 
to  require  A  to  indorse  such  notes,  thereby  making 
them  what  is  sometimes,  though  erroneously,  called 
two-name  paper.  On  the  other  hand,  if  conmiercial 
custom  is  such  that  B  will  regard  it  as  somewhat  of  an 
affront  or  reflection  if  A  asks  him  for  a  note,  the  result 
will  be  that  A's  assets  will  consist  of  open  book  ac- 


no  BANKING  AND  BUSINESS 

counts  or  "charge  accounts,"  and  that  when  A  goes 
to  his  bank  to  borrow  he  will  usually  be  able  to  offer 
the  banker  simply  his  own  note,  representing,  of  course, 
the  fact  that  he  owns  bona-fide  claims  upon  a  large 
number  of  customers  who  are  solvent  and  will  pre- 
sumably pay  for  the  goods  when  their  credit  period 
has  expired.  In  this  case  the  business  practice  of  the 
community  dictates  that  the  bank's  loans  shall  be 
largely  single-name  paper,  or  "straight"  notes. 

This  is  the  case,  although  in  a  somewhat  different  way, 
when  A  has  offered  B  a  discount  for  payment  in  cash, 
instead  of  payment  at  the  close  of,  say,  sixty  days. 
In  such  cases  the  buyer  B  will  haA^e  to  arrange  for  the 
financing,  and  to  the  extent  that  his  own  funds  are  in- 
sufficient, will  borrow  from  his  bank  and  take  the  cash 
discount.  Inasmuch  as  the  cash  discount  is  usually 
higher  than  the  customary  rate  of  interest,  buyers  will 
borrow  as  much  as  they  are  able  from  their  own  banks 
in  order  to  pay  the  seller  cash  and  receive  a  discount. 
Where  this  is  the  case,  they  will  give  their  bank  their 
own  promissory  note,  either  straight  or  indorsed,  or, 
less  frequently,  secured  by  collateral  of  one  kind  or 
another.  Those  buyers  who  are  unable  to  borrow  will 
be  carried  by  the  seller  in  the  manner  indicated  above, 
and  thus  the  cash  discount  serves  to  divide  buyers 
into  two  classes  and  to  provide  a  different  manner  of 
financing  each. 

III.  Use  of  Security. 

The  question  of  security  is  also  largely  determined 
for  the  banks  by  the  habits  of  the  customers.  While 
it  is  practicable  for  the  banker  to  exact  in  many  cases 
special  security  from  borrowers,  this  is  by  no  means 
always  good  business  pohcy.  In  some  cases,  in  fact, 
it  is  not  practicable.     Good  banking  is  not  pawn- 


FINANCING  THE   BUSINESS  MAN  ill 

broking  or  collateral  lending,  but  is  the  recognition  or 
cashing  of  current  titles  based  upon  values  growing  out 
of  ordinary  trade  and  unaccompanied  by  detailed  or 
particular  evidence  of  o\Miership  of  goods.  IMany  bank- 
ers who  have  not  enjoyed  a  very  broad  experience  seem 
to  suppose  that  good  banking  lies  in  making  sure  that 
every  loan  is  protected  by  a  claim  upon  property  which 
can  unquestionably  be  realized  upon  in  an  amount 
equal  to  the  sum  technically  ''advanced."  Banking, 
however,  in  order  to  be  sound  calls  for  liquidity  as  a 
primary  element  in  lending,  and  it  is  not  always  true 
that  such  hquidity  implies  or  carries  with  it  the  idea  of 
security.  In  such  cases  security  is  furnished  by  the 
general  flow  of  commodities  in  business,  and  the  effort 
to  tie  transactions  down  to  a  basis  of  direct  protec- 
tion is  not  feasible,  or  results  in  so  great  a  delay  and  so 
much  detail  in  connection  with  the  advance  that  the 
assistance  obtained  from  the  loan  is  greatly  reduced — 
sometimes  rendered  almost  valueless  to  the  recipient. 

It  might  be  supposed  from  what  has  been  said  that 
the  banker  had  no  control  over  the  forms  of  security 
which  his  customer  offered,  but  that  is  far  from  being 
the  case.  The  general  conditions  are  practically  estab- 
lished for  the  banker  as  a  result  of  custom  or  habit  in 
the  particulars  already  set  forth,  but  the  banker  can 
do  much  to  encourage  the  business  pubhc  in  improving 
its  methods  of  borrowing,  protecting  its  advances 
through  conservative  and  wise  management,  and  as 
opportunity  offers  strengthening  and  modifying  busi- 
ness practice  where  such  practice  is  open  to  doubt  or 
criticism.  Every  banker  owes  a  first  duty  to  his 
stockholders  and  to  those  who  have  intrusted  him  ^\^th 
funds  for  current  use.  He  must  not  unduly  hazard 
these  funds.  For  his  own  sake,  as  well  as  for  the 
business  prosperity  of  his  bank,  he  must  be  as  useful 
as  he  can  to  the  community,  but  in  the  main  he  must 


112  BANKING  AND  BUSINESS 

try  to  reconcile  these  different  requirements  with  one 
another. 


IV.  Sources  of  Credit  Information. 

It  is  now  time  to  see  in  what  practical  forms  the 
problem  of  financing  the  business  man  presents  itself. 
Probably  the  first  question  which  the  banker  has  to 
meet  in  this  connection  is  the  amount  of  credit  which 
he  is  wilUng  to  extend  to  the  customer.  In  American 
banking  practice  this  is  settled  through  the  estabhsh- 
ment  of  a  "hne  of  credit."  The  hne  of  credit  is  a 
statement  of  the  kinds  and  amounts  of  advance  which 
the  banker  is  "v\dlUng  to  make  in  the  case  of  a  given 
concern.  It  can  be  determined  only  after  a  very  care- 
ful survey  by  the  credit  department,  subject  to  later 
review  and  confirmation  by  the  proper  officers  of  the 
institution. 

Information  regarding  the  credit  standing  of  a  bor- 
rower may  be  obtained  directly  from  him  or  indirectly 
from  outside  sources.  The  borrower  himself  may  furnish 
the  bank  with  data  in  a  financial  statement  which 
summarizes  the  assets  and  liabilities  of  his  business, 
together  ^\ith  miscellaneous  information.  If  any  of  the 
items  in  this  statement  are  not  entirely  clear,  they  are 
then  considered  in  a  personal  interview  between  the 
borrower  and  an  officer  of  the  bank.  When  concerns 
are  seeking  an  especially  large  extension  of  credit, 
metropolitan  banks  at  times  retain  the  services  of 
experts  such  as  engineers  and  accountants  to  under- 
take an  intensive  inspection  of  the  plant  or  business. 

A  bank  does  not  rely  entirely  upon  information  which 
emanates  directly  from  the  prospective  borrower,  but 
also  gathers  facts  regarding  his  standing  from  other 
sources.  The  most  important  of  these  is  the  com- 
mercial   reporting    agency.      Such    reporting    organi- 


FINANCING  THE   BUSINESS  MAN   113 

zations  are  international  in  their  scope,  and  through  the 
operation  of  numerous  branches  and  thousands  of 
representatives  are  able  to  gather  credit  information 
regarding  firms  in  all  fields  of  business  activity.  The 
analyses  of  these  agencies  are  presented  in  reports 
which  give  the  history  and  a  financial  statement  of 
any  business  regarding  whom  inquiry  has  been  re- 
quested. In  addition,  the  commercial  agencies  com- 
pile books  which  contain  the  names  of  practically  all 
business  concerns  in  the  United  States  and  Canada, 
together  with  an  estimate  of  the  net  worth  or  capital 
and  of  their  credit  expressed  in  the  form  of  a  rating. 
Besides  these  general  agencies,  there  are  also  special 
organizations  which  collect  information  concerning  the 
firms  in  a  particular  line  of  business. 

A  bank  may  secure  further  credit  information  by 
communicating  with  persons  who  have  had  business 
deahngs  with  the  borrower  whose  credit  standing  is 
being  considered.  An  inquiry  is  therefore  addressed 
to  banks  which  have  carried  the  account  or  have  had 
business  transactions  with  the  person  or  firm  under 
investigation.  Satisfactory  information  may  also  be 
secured  by  soliciting  other  concerns  in  the  same  line 
of  business.  The  opinions  of  these  firms,  whether 
friendly  associates  or  active  competitors,  are  given  full 
consideration  in  determining  credit  ratings. 

Usually  the  individual  who  seeks  a  loan  is  at  the 
same  time  a  customer  of  the  bank,  and  so  additional 
facts  can  be  found  in  the  records  of  certain  departments. 
From  the  bookkeeping  department  the  average  de- 
posit balance  can  be  learned,  and  from  the  loan  and 
discount  departments  the  history  of  past  loans  can  be 
disclosed.  An  almost  limitless  mass  of  general  credit 
information  relating  to  applicants  for  loans  may  be 
uncovered  in  the  daily  newspapers  and  in  the  financial 
weeklies. 


114  BANKING  AND   BUSINESS 

The  information  thus  gathered  from  direct  and  in- 
direct sources  is  collected  in  credit  folders,  each  filed 
according  to  the  name  of  the  borrower.  This  record 
book  contains  the  business  history  of  the  applicant.  It 
also  includes  a  complete  financial  statement  of  his 
current  assets  and  liabilities,  and  a  comparative  survey 
of  these  items  covering  a  period  of  several  years. 
Interviews  by  officers  of  the  bank  and  reports  by  field 
investigators  are  presented  in  brief.  A  statement  is 
also  made  of  the  average  balance  and  extent  of  previous 
loans  of  the  borrower. 

V.  The  Borrower's  Statement. 

While  the  bank  thus  gathers  credit  information  from 
a  wide  variety  of  sources,  these  serve  merely  as  checks 
to  the  borrower's  financial  statement  or  property  blank 
which  really  constitutes  the  basis  of  an  unsecured  loan. 
Banks  sometimes  employ  a  general  statement  for  all 
borrowers,  but  usually  the  form  will  vary  according  to 
the  type  of  organization  and  the  nature  of  the  business. 
Thus  large  banks  use  separate  forms  for  individuals, 
firms,  and  corporations,  and  different  blanks  for 
farmers,  merchants,  and  manufacturers.  The  financial 
statement  presents  the  amount  of  the  borrower's  assets 
and  liabilities  usually  arranged  in  order  of  their  Hquid- 
ity.  Analysis  of  these  items  will  be  made  with  par- 
ticular reference  to  quick  assets  and  current  liabilities, 
for  these  are  of  especial  interest  in  determining  the 
credit  rating  of  a  prospective  borrower, 
a.  Assets. 

(1)  Cash  on  hand  and  in  bank.  Cash  on  hand 
covers  all  ready  money  found  in  the  safe  of 
the  borrower.  As  checks  are  claims  pay- 
able on  demand,  they  also  may  be  considered 
as  cash.     Promissory  notes  of  debtors  or 


FINANCING  THE  BUSINESS  MAN  iin 

the  personal  checks  of  business  associates 
must  not  be  regarded  as  cash  items. 

Cash  in  banks  is  composed  of  all  deposits 
payable  on  demand  and  so  will  not  embrace 
time  deposits  or  collection  items  such  as 
notes  and  drafts  for  which  deposit  credit  has 
not  as  yet  been  allowed. 

(2)  Notes    receivable.     These    obligations    ha^'e 

been  received  from  customers  in  paj-ment  of 
merchandise  actually  sold,  and  may  assume 
the  form  of  promissory  notes  or  accepted 
drafts.  This  item  should  not  include  notes 
from  salesmen,  employees,  partners,  stock- 
holders, or  officers  of  the  corporation.  The 
maturity  of  these  obligations  must  be  cur- 
rent, and  not  past  due,  renewed  or  in  the 
hands  of  attorneys  for  collection. 

(3)  Accounts  receivable.     A  firm  does  not  always 

receive  written  obligations  from  customers 
to  whom  goods  have  been  sold,  but  instead 
these  unpaid  charges  are  entered  as  accounts 
receivable  on  the  books  of  the  seller.  From 
the  item  of  accounts  receivable,  the  follow- 
ing should  be  excluded:  (a)  loans  to  part- 
ners or  officers,  (b)  advances  to  subsidiary 
concerns,  (c)  advances  to  salesmen,  (d) 
balances  covering  goods  shipped  to  a  selling 
agent  or  on  consignment  where  no  actual 
sale  has  been  effected,  (e)  items  long  overdue 
or  uncollectable,  (f)  accounts  assigned  and 
pledged  for  the  purpose  of  secui'ing  loans. 

(4)  Merchandise    and    inventory.     This    item    is 

composed  of  raw  materials,  goods  in  process 
of  manufacture,  or  comjiU^t^^ly  finished, 
which  are  still  unsold,  but  actually  owned 
by  the  borrower.     The  statement  usually 


116  BANKING  AND   BUSINESS 

draws  a  distinction  among  these  three 
classes,  for  they  vary  considerably  in  their 
relative  marketability.  Raw  material  is 
more  or  less  free  capital  which  can  be  ap- 
plied to  various  uses,  and  so  has  a  wider 
market  than  merchandise  in  a  finished  state. 
There  is  only  a  limited  demand  for  goods  on 
which  manufacturing  operations  have  been 
performed  but  have  not  as  yet  been 
completed. 

Merchandise  must  always  be  evaluated  on 
a  conservative  basis.  Naturally  the  credit 
man  cannot  accept  the  selling  price  at  which 
the  owner  hopes  to  dispose  of  his  goods. 
Instead,  merchandise  is  appraised  at  its 
lowest  value,  which  may  either  be  the  mar- 
ket price  or  the  cost  of  production.  The 
former  is  used  in  a  period  of  falling  prices, 
while  the  latter  is  employed  during  an 
upward  trend. 

(5)  Investments.     Cash,  notes  and  accounts  re- 

ceivable, and  inventory  are  regarded  as 
quick  assets.  To  this  group  the  item  of  in- 
vestments is  sometimes  added,  depending 
upon  the  nature  of  these  holdings.  United 
States  government  obligations,  listed  bonds, 
and  at  times  conservative  stocks,  are  readily 
convertible  into  cash,  but  securities  of  a 
speculative  nature  or  of  affiliated  com- 
panies are  rated  as  slow  assets. 

(6)  Plant.     This   class  also  includes  real  estate, 

buildings,  machinery,  and  general  equip- 
ment. Little  consideration  is  given  by  the 
bank  to  intangible  assets  such  as  trade- 
marks patents,  franchises,  leases,  and  good- 
will. 


FINANCING  THE   BUSINESS   MAN  117 

b.  Liabilities. 

(1)  Notes  payable.     These  are  debts  which  have 

arisen  from  the  purchasing  of  merchandise 
or  supphes.  Notes  payable  may  also  repre- 
sent sums  which  have  been  borrowed  from 
banks,  from  the  open  market  through  the 
aid  of  note  brokers,  or  from  private  in- 
dividuals such  as  stockholders,  partners, 
friends,  and  relatives. 

(2)  Accounts  payable.    Merchandise  and  supphes 

are  not  always  purchased  for  cash  or  in 
notes,  but  may  also  be  bought  on  open 
account.    This  item  corresponds  to  the  entry 

"accounts  receivable"  on  the  asset  side  of 

the  statement. 

(3)  Deposits.     These  funds  may  have  been  left 

by  stockliolders,  partners,  and  employees, 
and  are  subject  to  immediate  withdrawal. 

Deposits,  accounts,  and  notes  payable 
constitute  current  liabilities,  which  must  be 
analyzed  in  relation  to  quick  assets. 

(4)  Proprietorship.     This  includes  capital  stock, 

surplus,  and  undivided  profits. 
''5)  In  general  all  obligations  which  mature  after 
the  interval  of  one  year  may  be  safely 
counted  as  deferred  liabihties.  Considera- 
tion must  also  be  given  to  annual  sales  and 
various  reserve  items. 


VI.  Determination  of  Line  of  Credit. 

When  the  credit  department  has  reported  uiwn  the 
standing  of  a  given  borrower,  that  standing  must  be 
checked  and  analyzed  so  far  as  practicable  for  the  pur- 


118  BANKING  AND  BUSINESS 

pose  of  detecting  errors  or  flaws  and  of  introducing  the 
subsequent  changes  if  they  are  called  for.  The  final 
ascertainment  or  definition  of  the  "line"  is  allotted 
to  a  discount  committee  in  some  banks,  or  to  an 
executive  committee,  usually  in  consultation  with  the 
officers  of  the  institutions.  When  the  officers,  working 
with  the  committee,  have  settled  upon  the  amount  to 
be  advanced  in  the  aggregate,  the  actual  making  of  the 
loans  up  to  the  amount  specified,  and  the  taking  of  the 
proper  protection  for  each,  are  necessarily  intrusted 
to  the  executive  authorities  of  the  bank  who  are  under 
its  by-laws  in  charge  of  current  relations  with  cus- 
tomers. It  is  then  their  duty  to  follow  carefully 
and  with  attention  the  current  operations  of  the 
business  man  in  order  to  form  a  judgment  whether  his 
advances  are  being  wisely  used  and  whether  changes 
in  his  condition  occurring  from  time  to  time  are  of  such 
a  nature  as  to  warrant  a  modification  of  his  fine  of 
credit. 

Classical  banking  theory  has  always  held  to  the  view 
that  the  limit  of  the  bank's  advances  should  be  deter- 
mined by  the  current  turnover  of  the  business  man's 
operations.  This  may  be  stated  in  other  words  by 
saying  that  the  bank  should  not  advance  funds  for 
permanent  use  in  business.  Funds  which  are  re- 
quired either  for  investment  in  plant  or  for  current 
working  capital  should  be  obtained  through  issues  of 
stock  or  bonds,  and  should  be  a  part  of  the  regular 
assets  of  the  enterprise.  The  idea  may  be  put  in 
another  way  by  saying  that  the  amount  of  credit  which 
the  bank  extends  to  the  business  house  should  be  de- 
termined by  the  amount  of  credit  which  the  business 
house  extends  to  others.  Exactly  how  to  ascertain 
this  limit  upon  the  volume  of  credit  in  any  given  case 
is  a  technical  matter.  An  illustration  \\iU  suffice  to 
make  clear  what  is  meant.     Suppose  that  a  certain 


FINANCING  THE  BUSINESS  MAN  119 

enterprise  is  capitalized  at  8500,000,  all  of  which  is 
paid  in  in  cash.  The  concern  with  this  sum  of  money 
purchases  or  builds  a  plant  worth  $250,000.  It  invests 
$150,000  in  machinery  and  equipment.  The  $100,000 
balance  of  its  initial  $500,000  is  placed  in  bank  for  the 
purpose  of  meeting  current  expenses.  We  may  sup- 
pose that  the  concern  immediately  begins  manufactur- 
ing and  puts  salesmen  in  the  field  with  instructions  to 
dispose  of  the  goods.  In  advertising,  in  exploitation, 
in  the  pajonent  of  the  salaries  of  salesmen,  representa- 
tives, in  rentals,  and  in  various  other  ways  it  uses,  let 
us  say,  $75,000  before  it  has  begun  to  receive  a  large 
flow  of  orders.  Up  to  this  point  there  is  no  basis  for 
an  application  for  bank  credit.  The  business  has  in- 
vested its  capital,  and  what  it  has  to  show  by  way  of 
results  is  either  plant,  equipment,  or  goodwill.  Now 
it  may  be  supposed  that  as  the  result  of  its  operations 
it  begins  to  receive  a  volume  of  orders  which  result 
in  purchases  of  raw  material,  the  payment  of  wages 
to  labor,  and  in  other  expenditures  which  contribute 
to  the  actual  production  of  partly  finished  goods.  As 
the  goods  pass  into  the  hands  of  buyers  it  establishes 
on  its  books  accounts  representing  the  debts  due  from 
these  purchases.  The  concern  is  now  a  suitable  appli- 
cant for  bank  credit  and  the  amount  to  be  extended  by 
it  will  be  limited  by  its  expenditures  for  material  and 
labor,  as  well  as  for  delivery  costs  and  the  like,  and  will 
be  represented  by  open  accounts  on  its  books.  If  it 
applies  to  the  bank  for  funds  it  will  do  so  in  order  to 
realize  in  immediate  resources  what  is  expected  to  come 
in  to  it  Avithin  a  reasonable  credit  period.  The  bank 
supplies  these  funds,  and  is  able  to  do  so  because  other 
business  houses  which  are  at  more  advanced  stages  of 
the  process  of  production  and  distribution  are  currently 
depositing    their    receipts    with    it.     The    bank    thus 


120  BANKING  AND  BUSINESS 

equalizes  the  supply  of  available  funds  or  of  credit 
among  the  different  branches  of  business. 

VII.  Oversight  of  Use  of  Credit. 

As  has  thus  been  seen,  when  a  definite  line  of  credit 
has  been  assigned  to  the  business  man  the  first  step 
has  been  taken  toward  the  establishment  of  a  fixed 
relationship  between  him  and  his  banker.  The  banker, 
however,  has  a  second  and  very  important  part  to  play 
in  the  process  of  financing  his  customer.  This  con- 
sists in  overseeing  the  use  of  the  credit  and  so  far  as 
possible  aiding  the  customer  in  the  \\ise  emplo3Tnent 
of  it.  The  banker  is  not  called  upon  ordinarily  to 
interfere  with  the  doings  of  the  business  man  or  to 
exhibit  an  undue  inquisitiveness  about  his  transactions. 
It  is,  however,  essential  from  his  own  standpoint  that 
the  credit  which  he  extends  shall  be  as  nearly  liquid  as 
possible,  and  in  order  to  attain  this  end  he  is  called 
upon  to  watch  carefully  the  transactions  of  his  customer 
and  to  see  that  so  far  as  practicable  the  right  type  of 
paper  is  made  as  representing  given  classes  of  advances. 
For  example,  suppose  that  the  banker  has  come  to  the 
conclusion  that  customer  A  is  entitled  to  a  total  line 
of  credit  of,  say,  S100,000.  He  might  simply  permit 
the  customer  to  draw  on  him  for  this  amount  as  the 
latter  saw  fit,  giving  his  notes  as  he  used  the  cash.  It 
is  preferable,  however,  that  he  should  advise  with  the 
customer  and  reach  an  agreement  as  to  the  form  which 
the  advances  shall  take.  Thus,  it  may  be  that  the 
customer  has  drafts  coming  due  for  his  spring  stock  of 
merchandise  and  that  these  amount  to  $50,000.  By 
paying  them  immediately  he  can  obtain  a  discount  of, 
perhaps,  3  per  cent.  It  is  therefore  desirable  that  he 
arrange  with  his  banker  to  meet  these  drafts  as  they 
come  in.    Perhaps  this  will  be  done  through  a  direct 


FINANCING  THE    BUSINESS  MAN  121 

loan  to  the  customer,  evidenced  by  his  note,  or,  as  in 
foreign  trade,  it  may  be  accomplished  by  an  agreement 
on  the  part  of  the  bank  to  let  the  drafts  be  drawn  on  it, 
subject  to  immediate  payment  or  to  acceptance.  How- 
ever the  transactions  may  be  arranged,  the  fact  is  the 
bank  has  definitel}'  set  aside  SoO,000  out  of  the  entire 
line  for  the  purpose  of  liquidating  payments  to  be  made 
for  the  purpose  of  putting  goods  on  the  shelves.  Again, 
the  customer  maj^  show  in  his  statement  to  the  banker 
that  he  has  outstanding  at  all  times  about  S50,000  of 
good  accounts,  running  perhaps  sixty  daj^s.  The  ques- 
tion will  then  necessarily  come  up  whether  the  banker 
ought  to  let  him  have  direct  loans  on  the  strength  of  those 
accounts  up  to,  say,  50  or  GO  per  cent  of  their  amount. 
If  so,  this  may  mean  that  another  $25,000  is  tentati\'ely 
set  aside  subject  to  the  call  of  the  customer  for  the 
purpose  of  enabling  him  to  anticipate  the  amounts 
which  his  customers  are  expected  to  pay  him  within 
the  next  few  months.  It  may  be  that  the  business 
man  has  been  in  the  habit  of  selling  his  goods  on  what 
is  called  trade  acceptance;  in  other  words,  that  his 
customers  have  signed  acceptances  at  sixty  days'  sight 
when  they  received  the  goods,  or  it  may  be  that  he  has 
simply  sold  them  the  goods  on  open  account.  If  he 
has  trade  acceptances  in  his  safe,  it  may  be  thought 
best  to  say  to  him  that  he  may  discount  such  accept- 
ances up  to  a  gi\cn  percentage  or  to  the  whole  of  their 
face  value,  but  in  any  case  the  action  of  the  banker  is 
equivalent  to  telling  him  that  he  may  expect  as  a  part 
of  his  line  of  credit,  say,  $25,000  as  against  goods  sold. 
It  may  be  expected  that  this  portion  of  his  line  will  be 
increased  as  his  sales  increase,  provided  that  the 
character  of  his  own  customers  is  as  good  as  ever. 
The  important  point  is  that  an  allotment  of  credit 
against  sales  of  goods  has  been  made  to  him.  Evi- 
dently the  banker  will  expect  to  decrease  the  credit 


122  BANKING  AND  BUSINESS 

which  he  has  granted  against  merchandise  on  the 
shelves  as  the  stock  falls  off,  while  on  the  other  hand 
he  will  increase  the  amount  of  credit  granted  against 
book  accounts  or  trade  acceptances  as  the  outstanding 
claims  increase.  A  great  deal  has  been  said,  in  some 
discussions  of  this  subject,  of  the  relative  advantages 
of  trade  acceptances  and  of  straight  notes  as  a  basis 
of  bank  lending.  This  type  of  discussion  has  but  little 
basis.  There  is  no  particular  kind  of  paper  which 
entitles  a  customer  to  more  or  less  credit  at  the  bank, 
and  it  is  chiefly  a  matter  of  imagination  to  suppose  that 
the  conversion  of  open  accounts  into  trade  acceptances 
will  permit  the  banker  with  safety  to  lend  more  largely. 
In  considering  two-name  paper,  the  decision  of  the 
banker  whether  to  discount  or  not  is  invariably  based 
upon  what  he  knows  of  the  stronger  of  the  two  names. 
If  the  banker  is  financing  a  business  man  w^hose  sales 
are  largely  to  other  business  men  whose  names  are 
stronger  than  his  own,  there  may  be  some  advantage 
in  obtaining  from  the  latter  their  accepted  paper — 
provided  he  can  induce  them  to  give  it,  which  is 
usually  not  the  case.  But  if  the  business  man's  cus- 
tomers are  no  stronger  than  himself,  his  banker's  action 
in  discounting  is  determined  by  what  is  known  of  his 
own  financial  solvency. 

VIII.     Improvement    of    Methods    of    Business 

Finance. 

On  the  whole,  the  banker's  service  to  his  customer 
does  not  consist  in  devising  various  schemes  or  plans 
to  enable  him  to  get  credit,  but  does  consist  in  studj^ing 
his  credit  and  determining  the  amount  which  the 
business  man  may  safely  use.  When  this  amount  has 
been  settled  upon,  the  distribution  of  it  between  dif- 
ferent forms  is  primarily  a  matter  of  convenience  or 


FINANCING  THE   BUSINESS  MAN  123 

adjustment  to  business  practice.  It  is  undoubtedly 
the  function  of  tfie  banker  to  try  to  improve  business 
practice.  This  is  a  long  process  and  one  which  must 
be  undertaken  with  tact  and  judgment.  Success  in  it 
will  be  obtained  not  by  artificially  substituting  one 
kind  of  paper  for  another,  but  by  improving  the  under- 
lying basis  of  credit,  by  shortening  the  periotl  of  credit 
extension  where  that  is  too  great,  and  by  securing  the 
adoption  of  satisfactory  practices  on  the  part  of  the 
borrowers  themselves. 

The  banker,  however,  can  and  must  do  what  he  is 
able  to  help  his  customer  obtain  funds  as  economically 
as  possible.  This  means  that  he  should  and  will 
encourage  his  customer  to  create  paper  that  has  the 
widest  possible  marketability.  For  example,  under  the 
Federal  Reserve  system  certain  paper  is  eligible  to 
discount,  while  other  paper  is  not.  If  the  customer 
can  be  induced  to  present  his  paper  to  his  banker  in 
an  eligible  form,  the  latter  is  then  able  to  feel  assur- 
ance that  it  will  be  admitted  to  rediscount  at  Reserve 
bank  if  desired.  He  is,  therefore,  able  to  convert 
this  part  of  his  portfolio  into  immediate  funds  when- 
even  he  chooses,  and  for  that  reason  he  can  afford 
to  make  a  rate  to  the  customer  which  is  lower  than 
he  would  charge  were  the  paper  not  discountable  at 
the  Federal  Reserve  bank.  In  almost  all  cases,  the 
customer  who  is  doing  a  considerable  business  can  put 
a  portion  of  his  paper  into  such  a  form  and  can  thus 
obtain  the  advantage  of  the  lowest  market  rate. 
Then,  too,  it  may  appear  that  the  customer  is  financing 
his  business  by  unnecessarily  expensive  methods.  He 
may  not  be  taking  his  cash  discounts,  but  may  be  using 
his  funds  in  other  ways  so  that  his  purchases  of  goods 
are  unnecessarily  expensive.  The  banker  can  often 
show  him  how  to  reduce  his  costs  for  credit  by  obtain- 
ing the  closest  buying  prices  and  providing  him  with 


124  BANKING  AND   BUSINESS 

the  funds  to  take  advantage  of  them.  This,  of  course, 
impUes  good  management  on  the  part  of  the  business 
man  and  wilUngness  to  observe  the  general  suggestions 
of  the  banker  with  respect  to  the  distribution  of  his 
resources  among  the  various  purposes  to  which  they 
may  be  apphed  in  the  development  of  the  business.  It 
may  also  be  that  the  customer  has  fallen  into  the  habit 
of  granting  to  those  who  buy  from  him  an  unduly 
long  period  of  credit.  Analysis  of  his  statement  and 
comparison  of  his  borrowing  position  with  that  of 
similarly  situated  firms  in  the  same  line  of  business  will 
show  where  improvements  can  be  made.  The  banker  is 
probably  in  better  position  to  extend  help  of  this  kind 
than  anyone  else.  It  is,  of  course,  true  that  the  bank 
must  stand  ready  to  help  its  customer  in  adjusting 
himself  to  the  needs  and  requirements  of  the  trade 
he  is  carrying  on.  If,  for  example,  the  customer  is  an 
importer  and  the  foreign  seller  of  goods  insists  upon 
being  paid  through  the  issue  of  a  banker's  acceptance, 
the  banker  must  stand  ready  to  supply  credit  in  that 
form  if  such  action  is  requisite  in  order  to  meet  the 
requirements  of  the  foreign  market.  Out  of  this  grows 
the  fact  that  there  are  many  different  types  of  paper, 
and  that  even  in  the  most  conservatively  operated  bank 
the  portfoUo  will  frequently  include  all  or  a  majority 
of  them. 

IX.  Open-maeket  Borrowing. 

It  is  frequently  also  the  duty  of  the  banker  to  explain 
to  the  business  man  the  conditions  under  which  he 
may  obtain  credit  to  better  advantage  from  some  other 
source.  With  certain  types  of  concerns  there  is  always 
the  question  whether  better  results  can  be  obtained 
by  seeking  credit  in  the  open  market,  than  by  obtaining 
it  at  the  local  bank.    The  notes  of  the  borrower  are 


FINANCING  THE   BUSINESS  MAN  125 

thus  sold  on  a  competitive  basis,  which  is  supposed 
to  correspond  broadly  with  the  going  rate  of  interest 
which  exists  generally  at  that  time.  The  home  bank 
may  be  too  small  to  extend  so  large  an  amount  of 
credit,  or  it  may  be  in  the  habit  of  charging  a  high 
figure  simply  because  it  can  get  that  from  other  bor- 
rowers. Perhaps,  therefore,  the  business  man  may 
think  it  well  to  obtain  a  wider  sale  for  his  paper  by 
offering  it  in  the  way  just  sketched.  If  he  does  so, 
competition  is  established,  and  the  result  has  been  to 
divide  his  credit  line  between  his  own  bank  and  the 
general  banking  and  investment  field.  If  his  banker 
is  kept  advised  of  the  amount  of  such  open-market 
advances,  no  harm  is  done  from  the  credit  standpoint, 
but  the  banker  is  able  to  regulate  his  own  extensions 
of  credit  accordingly.  Sometimes  it  may  be  well  for  him 
to  advise  the  borrower  to  place  his  financing  in  the  open 
market,  through  the  aid  of  a  commercial-paper  house. 
As  previously  mentioned,  this  type  of  banking  institu- 
tion acts  as  an  intermediary  between  borrowers  and 
lenders.  It  purchases  outright  the  obligations  of  busi- 
ness houses  in  need  of  funds  and  sells  them  to  individ- 
uals and  institutions  seeking  employment  for  surplus 
funds.  Firms  which  thus  borrow  on  the  open  market 
must  possess  large  resources  in  order  to  attract  buyers 
for  their  paper,  and  so  their  capitalization  is  seldom 
less  than  $200,000  when  money  is  easy,  and  S500,000 
or  so  when  there  is  stringency.  Their  paper  is  bought 
largely  by  banks.  The  commercial-paper  firm  thus 
serves  as  an  agency  for  the  distribution  of  liquid  capital 
from  places  where  there  is  a  surplus  to  other  localities 
where  there  is  a  need. 

The  commercial-paper  business  is  organized  on  a  na- 
tional scale.  The  bulk  of  the  business  is  done  by  about 
fifteen  large  houses  ha\'ing  branches  or  correspondents 
in  important  money  centers,  each  with  a  local  force  of 


126  BANKING  AND  BUSINESS 

salesmen.  A  large  commercial-paper  house  thus  has 
a  turnover  amounting  to  hundreds  of  millions  of  dollars 
every  year,  and  must  possess  much  the  same  charac- 
teristics as  are  found  in  a  strong  bank.  The  firm 
needs  adequate  financial  worth  in  order  to  carry  large 
blocks  of  paper  until  sold.  For  this  purpose  credit  is 
also  needed,  and  so  it  is  important  for  a  conmiercial- 
paper  house  to  establish  good  banking  connections. 
As  it  is  lending  vast  sums  of  money  to  borrowers  on 
their  credit  alone  and  without  any  collateral,  the 
commercial-paper  house  must  maintain  an  efficient 
credit  department  to  analyze  the  statements  and  re- 
ports of  firms  who  wish  to  place  their  obligations  on 
the  m.arket.  Also  a  trained  selling  force  is  essential 
in  order  to  dispose  of  the  paper  which  the  house  is 
handling. 

The  open-market  paper  usually  takes  the  form  of  a 
straight  single-name  promissory  note  which  is  uncol- 
lateraled.  It  differs  somewhat  from  the  ordinary 
promissory  note  in  that  the  maker  is  at  the  same  time 
the  payee  of  the  obligation,  which  usually  reads,  "Pay 
to  the  order  of  ourselves."  The  note  is  then  indorsed 
in  blank  on  the  reverse  side  by  the  maker  hmiself.  At 
times  it  is  further  indorsed  by  officers,  who  thus 
strengthens  the  obligation  by  adding  their  personal  lia- 
bility to  the  paper.  The  maturity  of  these  notes  is  usu- 
ally six  months,  but  the  time  may  be  as  short  as  three 
months.  These  notes  are  issued  in  even  denomina- 
tions of  $2,500,  $5,000,  and  $10,000,  the  proportions 
depending  upon  whether  larger  city  or  smaller  country 
banks  are  buying  the  paper.  The  commercial-paper 
house  imposes  a  charge  of  one-fourth  of  one  per  cent 
of  the  face  value  of  the  note,  irrespective  of  maturity, 
which  it  deducts  from  the  amount  it  pays  the  borrower. 
In  all  cases  the  borrower  receives  the  funds  at  once, 
regardless  of  when  the  commercial-paper  house  sells  the 


FINANCING   THE   BUSINESS  MAN  127 

paper,  but  in  some  cases  the  rate  is  "left  open,"  and 
the  charge  to  the  borrower  represents  the  rate  at  which 
the  paper  is  actually  sold  plus  the  commission. 

The  commercial-paper  market  is  an  essential  factor 
in  the  financial  structure  of  the  United  States,  where  the 
independent  banking  system  by  itself  would  tend 
merely  toward  local  use  of  funds.  Because  of  govern- 
ment regulations  a  large  borrower  at  the  same  time 
cannot  receive  sufficient  accommodation  from  a  single 
bank,  and  it  is,  therefore,  necessary  to  tap  outside 
sources  of  credit. 

The  open  market  also  presents  distinct  advantages 
to  the  thousands  of  small  banks  throughout  the  United 
vStates.  They  thus  possess  a  means  of  in\-esting  funds 
for  which  there  is  no  demand  in  the  immediate  locality. 
By  holding  the  obligations  of  firms  in  outside  localities 
they  are  not  dependent  on  the  prosperity  of  home 
industries. 

X.  Relation  Between  Business  Man  and  Banker 
IN  Time  of  Financial  Stress. 

One  phase  of  the  relation  of  the  bank  to  the  business 
man  and  the  latter's  financing  which  should  be  care- 
fully thought  of  is  the  condition  which  exists  in  time 
of  financial  strain  or  panic.  This  is  a  matter  on  which 
a  great  difference  of  opinion  has  often  been  expressed. 
The  bank  which  finds  itself  hard  pressed  by  its  cus- 
tomers is  inclined  to  curtail  its  loans  and  cut  down  its 
commitments,  and  in  so  doing  to  make  credit  conditions 
more  difficult  for  the  customer.  If,  for  example,  a 
bank  has  been  carrying  a  very  large  line  of  credit,  but 
business  depression  or  unemployment  among  de- 
positors is  leading  to  heavy  drafts  upon  it  so  that  it  is 
losing  ground,  the  natural  instinct  of  the  banker  is 
that  of  self-preservation.     In  order  to  trim  his  sails. 


128  BANKING  AND   BUSINESS 

he  cuts  down  the  new  credits  which  he  extends,  or 
raises  them  so  high  as  to  discourage  them.  At  all 
times  it  is  a  primary  duty  of  the  banker  to  keep  solvent 
and  to  be  able  to  meet  his  existing  obligations,  but  in 
so  far  as  is  consistent  with  this  one  primary  necessity 
the  first  duty  of  the  banker  is  to  his  business  customers 
and  consists  of  tiding  them  over  emergencies.  This 
does  not  mean  that  the  banker  is  called  upon  to  take 
undue  risks  or  to  make  gifts  to  his  customers,  but 
merely  that  the  function  of  banking  is  that  of  acting 
as  a  regulator  or  "governor."  When  business  de- 
pression occurs  and  customers  find  it  difficult  to  collect 
the  debts  due  them,  they  are  obliged  to  ask  for  exten- 
sions of  credit.  The  ^vise  banker  endeavors  to  ''carry" 
them  for  a  sufficiently  long  period  to  enable  them  to 
work  out  of  their  difficulties  and  to  ''get  on  their  feet." 
If  a  banker  is  not  able  to  take  this  course,  the  effect 
of  hasty  liquidation  is  often  that  of  forcing  the  closing 
of  business  houses  or  very  undue  curtailment  of  opera- 
tions, with  corresponding  loss  of  markets,  sacrifice 
of  prestige  and  goodwill,  and  perhaps  permanent 
damage  to  the  enterprise.  Every  bank  is,  of  course, 
obliged  to  reckon  upon  a  fixed  maturity  for  its  paper, 
and  when  that  becomes  impossible  through  the  failure 
of  business  men  to  pay  or  through  requests  for  re- 
newals, the  bank  finds  that  a  part  of  its  portfoho  is 
"frozen."  This  frozen  credit  consists  of  the  notes  of 
the  enterprises  which  have  been  unable  to  liquidate. 
The  banker  can  get  cash  for  such  paper  only  by  forc- 
ing the  business  man  to  settle,  which  frequently  in- 
volves, as  just  seen,  serious  loss  or  perhaps  destruction 
of  his  business.  It  is  in  such  circumstances  that  a 
rediscount  institution  can  exercise  an  exceptionally  help- 
ful function  in  the  community.  By  furnishing  bankers 
with  funds  sufficient  to  enable  them  to  carry  their 
customers,  it  relieves  the  strain  of  business  depression 


FINANCING  THE   BUSINESS   MAN  129 

from  any  particular  section  or  group  of  business  men 
and  equalizes  it  throughout  the  community.  It  thus 
makes  the  "carrying"  of  sound  and  solvent,  but  tem- 
porarily slow,  paper  a  matter  for  the  entire  banking 
community,  as  represented  by  an  institution  which 
combines  the  fluid  resources  of  the  community. 

This  is  the  same  service  that  was  performed  in  earlier 
days  by  the  clearing  houses  of  the  United  States  when 
they  arranged  to  issue  clearing-house  certificates  which 
were  practically  a  means  of  lending  upon  the  assets  of 
hard-pressed  banks  among  their  own  number.  Such 
work  on  the  part  of  the  clearing  houses  was  often  tech- 
nically undertaken  for  the  purpose  of  "saving"  a  given 
bank  or  banks,  but  this  thought  when  analyzed  further 
means  that  it  was  undertaken  for  the  purpose  of  pre- 
venting such  banks  from  the  attempt  to  save  them- 
selves by  forcing  too  hasty  Uquidation  on  the  part  of 
their  customers.  The  service  rendered,  although  tech- 
nically to  banks,  was  actually  to  the  business  com- 
munity. This  is  merely  another  way  of  sajdng  that, 
since  business  is  a  plant  of  slow  growth,  reduction  or 
curtailment  of  it  must  also  be  slowly  effected,  and  that 
banking  is  the  means  by  which  such  control  over 
expansion  and  contraction  is  exercised.  The  banker, 
therefore,  has  quite  as  serious  and  important  a  duty 
to  perform  in  connection  with  the  business  which  has 
reached  the  point  where  curtailment  must  take  place 
as  he  has  in  his  relations  to  the  business  which  is 
gradually  expanding  and  which  merely  needs  to  be 
fed  with  accommodation.  It  is  quite  true  that  if  all 
banks  were  managed  with  the  highest  A^sdom  during 
periods  of  business  growth,  inflation  and  depression 
would  probably  be  far  less  extreme  than  they  were 
during  1920  and  1921.  It  will  probably  never  be  true, 
however,  that  we  shall  be  able  through  regulation  of 
credit,   however  scientific,   to  bring   about  so  finely 


130  BANKING  AND  BUSINESS 

adjusted  a  balance  as  is  thus  indicated.  So  long  as 
there  are  ups  and  downs  in  business,  with  some 
enterprises  expanding  too  rapidly,  the  function  of  the 
banker  in  cushioning  the  blow  of  business  depression 
and  preventing  the  spread  of  failures  by  helping  to 
take  care  of  the  interests  of  those  concerns  which  are 
temporarily  embarrassed,  will  always  be  an  important 
one.  It  is  this  responsibility,  perhaps  more  than  any 
other,  which  warrants  the  banker  in  demanding  to  be 
constantly  informed  of  changes  in  the  condition  of  those 
who  borrow  heavily  from  him. 


CHAPTER  IX 

BANK   rORTFOLIOS 

I.  Limitations  on  Lending  Power  of  a  Bank. 

In  studying  the  financing  cf  different  kinds  of 
enterprises  from  the  point  of  view  of  the  borrower,  it 
must  not  be  forgotten  that  a  general  limiting  condition 
underlying  the  whole  question  of  financing  the  business 
is  found  in  the  condition  of  the  bank  and  its  ability 
to  do  what  the  borrower  desires.  In  what  has  already 
been  said  it  has  been  assumed  or  taken  for  granted 
that  the  bank  had  the  power  within  certain  limits  to 
direct  its  credit  practically  into  any  channel  that  it 
may  choose.  This  is  true  up  to  a  certain  point.  There 
are  two  considerations,  however,  which  always  limit 
the  power  of  the  bank  to  lend  to  a  given  concern,  and 
which  must,  therefore,  be  constantly  borne  in  mind  by 
the  borrower,  as  well,  of  course,  as  by  the  banker 
himself,  in  his  relations  with  the  borrower.  The  first 
of  these  considerations  is  that  the  bank  must,  in  its 
capacity  of  a  semipublic  institution,  distribute  its 
credit  over  the  different  classes  of  borrowers  in  such  a 
way  as  reasonably  to  meet  their  requirements.  It  is, 
of  course,  true  that  a  given  bank  may  specialize  in  a 
particular  kind  of  paper,  or  may  confine  itself  largely 
to  a  particular  industry  or  type  of  business.  But  when 
we  consider  the  bank  not  as  a  single  institution,  but 
as  one  of  a  group  of  institutions,  it  is  evident  that  pro- 
vision has  to  be  made  for  the  credit  needs  of  the  entire 
community.    This  means  that  banks  as  a  whole  must 


132  BANKING  AND   BUSINESS 

provide  for  filling  the  requirements  of  their  borrowers, 
and  in  order  to  do  so  must  keep  in  mind  some  general 
plan  of  distribution.  For  instance,  if,  in  a  country 
community  where  there  is  only  one  bank,  that  institu- 
tion should  concentrate  its  entire  lending  power  upon  a 
very  few  businesses,  the  bulk  of  the  conmiunity  would 
be  left  without  credit  accommodation.  It  is  in  order 
to  prevent  a  danger  of  this  kind,  possibly  resulting 
from  the  control  of  the  bank  by  persons  who  want  to 
absorb  its  entire  credit-granting  power,  that  the 
National  Banking  Act  endeavors  to  restrict  the  total 
amount  of  the  loans  granted  to  any  one  person  or 
corporation  to  a  specified  percentage  of  its  capital  stock. 
This  provision  of  law  was  partly  due,  no  doubt,  to  the 
desire  to  prevent  the  bank  from  "putting  all  of  its  eggs 
into  one  basket,"  but  it  was  also  due  to  the  desire  to 
insure  a  fairly  broad  distribution  of  credit.  The  second 
general  consideration  which  limits  what  the  bank  can 
do  in  any  single  direction  is  that  there  is  a  well-defined 
necessity  for  preventing  the  unnecessary  or  excessive 
expansion  of  given  types  of  business.  In  a  competitive 
community  there  is  always  a  danger  that  business  will 
be  unduly  expanded  or  increased  in  some  particular 
industry.  In  fact,  past  crises  or  commercial  depres- 
sions have  often  been  aggravated  by  undue  development 
of  one  line  of  business,  resulting  in  a  breakdown  in  that 
line,  due  to  the  fact  that  too  great  a  volume  of  goods 
was  produced  there  and  that  it  was  suddenly  reaUzed 
that  the  demand  did  not  sufiBce  to  carry  off  the  goods. 
When  banks  have  allowed  themselves  to  become  too 
closely  involved  with  institutions  representing  one 
principal  industry,  they  find  that  a  part  of  their  credit 
is  ''frozen"  or  rendered  unavailable  because  they 
cannot  compel  borrowers  to  reahze  without  driving 
them  into  bankruptcy.  This  would  result  in  forcing 
the  customer  to  throw  upon  the  market  large  stocks  of 


BANK   PORTFOLIOS  133 

goods  which  could  not  be  sold  at  a  remunerative  price, 
and  which  must  wait  until  better  conditions  have  been 
restored  in  that  branch  of  business.  Sound  banking, 
therefore,  dictates,  not  only  from  the  standpoint  of  the 
bank  itself,  but  also  from  that  of  the  proper  balancing 
of  different  Unes  of  business,  a  distribution  of  assets 
and  risks. 

It  thus  becomes  necessary  for  the  banker  to  consider 
and  analyze  carefully  the  composition  of  his  assets 
and  to  arrange  them  not  only  by  maturities,  but  by 
kinds  of  application,  on  a  well-ordered  plan.  Such  a 
digested  and  arranged  scheme  of  bank  assets  is  called 
the  portfoho  of  a  bank,  and  the  problem  of  the  bank 
in  connection  \\ith  it  is  simply  to  develop  a  holding 
which  represents  different  kinds  of  risks  and  a  fair 
distribution  of  the  bank's  loans  among  its  different 
classes  of  customers. 

In  working  out  this  problem  satisfactorily,  the  bank 
is  largely  guided  by  the  special  and  peculiar  conditions 
in  its  own  locality.  For  example,  let  us  consider  again 
the  case  of  the  country  bank  of  a  moderate  size  which 
is  alone  in  its  community  and  has  no  competition,  and 
which,  therefore,  has  the  greater  duty  of  a  public  sort 
to  consider  all  classes  of  demands.  Such  a  bank,  we 
may  suppose,  has  seasonal  requests  from  the  farmers 
surrounding  it  for  loans  to  be  used  in  gro\\'ing  and 
harvesting  their  crops.  It  also  has  demands  from 
dealers  in  a  retail  community  for  funds  to  assist  them 
in  meeting  their  purchases  of  goods  and  to  some  extent 
in  carrying  them.  Probably  such  a  bank  will  also 
have  some  call  for  fairly  long-term  real-estate  loans 
whose  proceeds  are  to  be  used  in  dex'eloping  or  purchas- 
ing properties.  There  may  also  be  a  local  manufactur- 
ing ent^erprise  or  two  which  has  need  of  the  services  of 
the  bank  in  financing  the  movement  of  raw  mat-erials 
into,  and  of  finished  products  out  of,  the  plant.     In 


134  BANKING  AND  BUSINESS 

this  connection,  and  others,  also,  the  bank  may  be 
called  upon  to  provide  a  considerable  amount  of 
domestic,  and  perhaps  some  foreign,  exchange.  Here 
is  a  complex  problem  of  the  division  of  credit. 

II.  Contents  of  the  Bank's  Portfolio. 

The  bank's  object  must  be  primarily  that  of  insuring 
its  own  liquidity  and  solvency  at  the  same  time  that  it 
distributes  its  funds  fairly  and  equitably  among  the 
different  elements  in  its  clientele.  First  of  all,  it  needs 
to  analyze  its  habilities  in  a  careful  and  scientific 
manner.  We  may  assume  that  the  bank  has,  let  us 
say,  $250,000  of  capital  and  that  it  has  succeeded  in 
developing  a  deposit  line  of,  say,  $750,000.  Analysis 
shows  that  of  this  deposit  line  $250,000  is  in  time 
deposits  or  certificates  of  deposit  which  move  very 
slowly  and  are  practically  continuously  renewed. 
This  leaves  $500,000  of  demand  deposits,  and  a  study 
of  them  makes  it  reasonably  sure  that  there  will  be  a 
rapid  turnover  only,  say,  in  the  spring  and  again  in  the 
autumn.  The  bank  is  therefore  in  position  first  of  all 
to  invest  its  funds  in  assets  of  fairly  long  and  non- 
liquid  character  corresponding  to  its  $250,000  of 
inactive  deposits.  Perhaps  it  may  carry  a  part  of  this 
amount  in  real-estate  mortgages  or  it  may  think  well 
to  invest  a  portion  in  sound  bonds  or  government 
obligations.  It  thus  has  as  the  basis  of  its  portfolio 
some  long-term  securities,  part  of  which  (the  real- 
estate  securities)  will  not  mature  for  a  great  while  and 
hence  are  not  liquid,  while  other  portions  (government 
securities)  will  not  mature  for  a  long  time,  but  are  very 
salable  and  hence  may  be  realized  in  case  of  necessity. 
These  may  be  considered  Section  1  of  its  portfoho. 

Behind  the  demand-deposit  hne  the  banker  probably 
has  an  approximately  equal  amount  of  current  notes  and 


BANK   PORTFOLIOS  135 

other  relatively  short-term  obligations.  These  may 
run  from  a  few  days  up  to  six  months  or  more,  and  it 
should  be  the  effort  of  the  banker  first  of  all  to  arrange 
their  maturities  in  such  a  way  as  to  have  them  fall  due 
steadily  and  successively,  so  as  to  provide  him  with 
the  cash  he  needs  to  meet  the  current  drafts  upon  him. 
For  instance,  if  he  has  found  that  during  the  months  of 
March  and  April  of  each  year,  and  again  during  the 
months  of  September  and  October,  he  is  obliged  to 
make  very  heavy  outlays,  his  depositors  drawing  on  him 
and  reducing  their  deposits  correspondingly  in  order 
that  they  may  liquidate  indebtedness  for  goods,  or 
may  transfer  their  funds  to  other  places,  he  evidently 
needs  to  have  maturities  of  fully  equal  amount  fall 
due  at  about  that  time.  This  is  for  the  purpose  of 
providing  him  with  cash  in  order  that  he  need  not 
reduce  his  reserve  below  its  normal  or  average  lev^el. 

Section  2  of  his  portfolio  may,  therefore,  be  conceived 
of  as  consisting  of  fairly  long-term  loans  which,  how- 
ever, are  unquestionably  payable  at  maturity  and 
which  have  been  "bunched"  so  that  their  maturities 
will  fall  due  in  such  a  way  as  to  meet  the  demands 
which  are  brought  to  bear  upon  the  banker  at  the 
"peak"  periods. 

The  banker,  however,  has  to  reckon  upon  a  regular 
steady  flow  of  funds  out  of  the  bank.  He  is  providing 
cash  for  the  community,  and,  while  he  expects  about 
an  equal  amount  of  income,  he  cannot  be  absolutely 
sure  of  it.  He  will  therefore  endeavor  to  carry  enough 
paper  falling  due  from  day  to  day  or  from  week  to  week 
to  enable  him,  if  he  finds  it  necessary,  to  reduce  his 
portfolio  by  failing  to  make  new  loans  or  refusing  to 
renew  old  ones,  and  thus  get  in  the  cash  which  he  needs 
to  meet  the  regularly  recurring  demands  to  which 
reference  has  just  been  made.  This  element  of  rela- 
tively short-time  paper,  which  probably  consists  in  his 
10 


136  BANKING  AND  BUSINESS 

case  primarily  of  the  obligations  of  local  merchants, 
may  be  regarded  as  Section  3  of  his  portfolio. 

The  banker,  however,  will  not  have  been  in  business 
very  long  before  he  will  find  that  a  good  many  of  the 
assets  in  Sections  1,  2,  and  3  of  his  portfolio  have  a 
purely  local  value  and  market.  For  instance,  the  note 
of  A,  secured  by  a  mortgage  on  his  farm,  could  be  sold 
to  some  local  investor  if  one  could  be  found,  but  it 
cannot  be  disposed  of  elsewhere.  The  note  of  B,  a 
local  merchant,  may  have  been  made  in  such  a  way  as 
to  have  been  rediscountable  at  the  Federal  Reserve 
bank  of  his  district,  but  on  the  other  hand  it  may  not 
have  been  made  thus  "eligible."  The  banker  in  lend- 
ing to  B  and  to  others  in  a  like  situation  will  probably 
endeavor  to  have  their  obligations  made,  so  far  as 
possible,  on  a  rediscountable  basis,  but  his  efforts  to 
bring  that  about  will  be  only  partially  successful.  He 
probably  will  come  to  the  conclusion,  therefore,  that  it 
is  desirable  for  him  to  have  in  his  portfolio  an  element 
of  what  is  called  "purchased  paper,"  w^hich  means 
paper  that  he  has  bought  outside  of  his  own  immediate 
community  and  which  represents  obligations  of  large 
concerns  to  whom  he  has  no  direct  or  personal  relation- 
ship, and  which,  therefore,  can  be  collected  presumably 
without  effort  on  the  part  of  their  makers  to  obtain 
extensions. 

This  element  of  paper,  which  we  may  designate  as 
Section  4  of  the  portfolio,  is  obtained  through  note 
brokers  or  dealers  in  commercial  paper  in  the  financial 
sections  of  the  country.  How  great  it  shall  be  is 
always  a  matter  of  some  doubt,  depending  in  a  measure 
upon  the  extent  to  which  the  banker  can  actually  spare 
funds  from  his  community.  The  banker,  moreover, 
will  find  that  he  is  frequently  called  upon  to  furnish 
exchange,  and  while  he  may  do  this  through  his  Federal 
Reserve  bank  so  far  as  the  demand  is  of  a  domestic 


BANK   PORTFOLIOS  137 

nature,  the  local  factory  to  which  reference  has  already 
been  made  may  occasionally  want  a  draft  on  some  for- 
eign country  in  order  to  purchase  goods  from  abroad. 
To  supply  such  demands  the  banker  must  either  open 
accounts  abroad  or  else  operate  through  another  bank 
which  has  done  so,  and  in  ordinary  circumstances  the 
latter  will  be  the  course  pursued  by  him.  He  will 
maintain  an  account  with,  let  us  say,  a  New  York  bank 
which  has  foreign  connections,  and  by  arrangement 
with  this  bank  he  will  sell  exchange  drawn  upon  those 
foreign  connections.  He  may  also  discount  the  paper 
drawn  by  the  local  factory  upon  foreign  buyers,  and 
thus  he  may  establish  a  small  element  in  his  portfolio 
which  can  be  designated  as  Section  5,  consisting  of 
actual  documentary  bills  of  exchange. 

If  it  be  desired  to  complete  the  classification,  we  may 
speak  of  his  balance  with  the  Federal  Reserve  bank 
and  ^vith  a  correspondent  bank  or  banks  in  neighboring 
cities  as  Section  6  of  the  portfolio,  consisting  of 
claims  on  other  banks  part  of  which  are  reserve  and 
part  of  which,  although  not  technically  reserve,  can 
easily  be  converted  into  that  class. 

III.  Problems  in  Developing  a  Portfolio. 

This  simple  analysis  or  outline  of  the  country  bank's 
portfoHo  is  intended  merely  as  a  cross  section  of  the 
bank's  operations  and  throws  no  Hght  upon  the  dif- 
ficulties that  have  been  encountered  in  developing  it. 
As  a  matter  of  fact,  the  banker  will  always  have  serious 
problems  to  confront  in  connection  ^ith  the  distribu- 
tion of  his  funds  between  the  various  uses  to  which  they 
are  to  be  put.  He  will  almost  always  find  that  there  is 
a  larger  demand  for  loans  in  the  community  than  he 
thinks  it  on  the  whole  wise  to  comply  with.  Were  he 
to  "tie  up"  his  entire  funds  on  advances  on  farm  lands 


138  BANKING  AND   BUSINESS 

he  would  soon  find  that  he  was  .short  of  means  with 
which  to  meet  the  regular  demand  of  depositors.  On 
the  other  hand,  should  he  confine  himself  entirely  to 
local  loans  he  might  find  at  periods  of  exceptional 
stringency  that  he  could  not  collect,  and  in  that  case 
he  would  have  no  assets  commanding  a  wide  market. 
Only  experience  and  day-to-day  observation  can  put 
the  banker  into  position  to  make  a  satisfactory  distribu- 
tion of  his  funds  as  between  the  different  elements  of 
his  portfolio.  The  problem  becomes  more  and  more 
complex  as  the  business  of  the  bank  grows  more  com- 
plex, and  in  the  case  of  the  city  banker  assumes  a 
seriousness  and  importance  which  cannot  be  over- 
estimated. The  proper  arrangement  of  the  portfoho 
in  the  great  banks  of  the  cities  is  really  a  primary  prob- 
lem in  the  management  of  the  bank.  It  is  often  found 
that  a  given  institution  has  perfectly  sound  and  un- 
questionable assets,  yet  is  embarrassed  because  of  the 
fact  that  these  assets  are  not  adapted  to  produce  the 
cash  that  is  needed  to  enable  it  to  meet  its  liabilities. 
This  forces  the  bank  to  dispose  of  its  assets  sometimes 
at  serious  sacrifice  in  order  to  meet  sudden  demands 
upon  it.  A  badly  adjusted  portfolio,  moreover,  as 
we  have  already  seen,  implies  a  bad  adjustment  of 
credit  in  the  community  as  between  the  different  ele- 
ments of  industry  and  trade. 

Without  attempting  to  emphasize  more  fully  the 
importance  of  the  portfolio  from  the  standpoint  of  good 
banking,  something  should  also  be  said  of  the  problem 
of  the  portfoho  from  the  larger  standpoint  of  credit 
and  business  in  general.  There  was  a  time  in  banking 
when  each  institution,  particularly  in  the  case  of 
American  banks,  was  conducted  largely  upon  the  theory 
that  it  was  an  entity  complete  in  itself  and  independent 
of  all  others.  That  period  has  long  since  passed,  and 
it  is  conceded  to-day  that  no  bank  can  estabhsh  a  very 


BANK  PORTFOLIOS  139 

sound  or  satisfactory  portfolio  for  itself  without  the 
full  co-operation  of  others  who  join  with  it  in  adopting 
a  general  policy  of  management.  It  is  because  of  the 
difficulty  of  doing  this  through  \'oluntary  action  on 
the  part  of  banks  that  central  banking  is  so  necessary 
and  that  the  Federal  Reserve  system  of  the  United 
States  has  been  established.  In  the  Federal  Reserve 
system  there  is  provided  a  means  of  developing  a  joint 
banking  policy  which,  before  its  organization,  could  be 
supplied  only  by  the  composite  action  of  the  banks 
associated  together  in  clearing  houses  or  in  bankers' 
associations.  Such  purely  informal  and  unofficial 
union  among  the  banks  was  ah\  ays  sporadic,  but  it  was 
found  necessary  at  times  to  enforce  given  lines  of 
action  in  the  interest  of  the  entire  community  by 
insisting  upon  the  adoption  of  certain  policies  on  the 
part  of  the  banks  themselves.  This  attempt  was  never 
fully  successful,  and  even  when  most  successful  was 
enforced  only  with  great  difficulty. 

IV.  Establishing  a  Sound  Bank  Portfolio. 

In  a  general  way  the  problem  of  establishing  a  sound 
bank  portfolio  can  be  solved  only  through  a  careful 
study  of  general  business  conditions.  The  tune  has 
passed  when  a  mere  inquiry  into  the  solvency  of  a  given 
concern  was  enough  to  show  that  its  paper  was  safe. 
If  at  the  same  time  other  concerns  in  the  industry  are 
being  unduly  promoted  by  the  use  of  the  bank's  credit, 
the  effect  may  be  a  sudden  expansion  in  that  line,  with 
the  concomitant  effect  of  overproduction  of  goods  and 
the  bad  results  that  have  been  referred  to  at  an  earlier 
point.  These  may  be  avoided  only  through  knowledge 
on  the  part  of  the  banker  regarding  the  general  condi- 
tion of  trade  and  industry,  his  purpose  being  always 
that  of  seeing  to  it  that  no  act  of  his  results  in  over- 


140  BANKING  AND   BUSINESS 

financing  firms  which  are  engaged  in  a  line  that  is 
already  fully  up  to  the  level  that  is  permitted  or  rendered 
profitable  by  the  demand  of  the  community.  For  in- 
stance, suppose  that  a  banker  has  a  client,  a  large 
automobile  factory,  which  has  always  met  its  paper 
promptly.  The  manufacturer  of  automobiles  having 
been  successful  in  producing  an  output  of,  let  us  say, 
1,000  cars  per  month,  is  planning  to  recapitalize  his 
company  and  to  double  his  output.  He  will,  however, 
before  taking  such  a  step,  probably  consult  with  his 
banker.  At  such  a  time  the  question  is  properly  raised 
whether  demand  for  automobiles  is  such  as  to  warrant 
the  doubling  of  this  particular  factory.  It  may  be  that, 
although  the  total  supply  of  cars  in  the  country  is 
excessive,  the  output  of  a  particular  kind  of  car  is 
still  insufficient,  so  that  the  banker  may  well  be  war- 
ranted in  agreeing  to  increase  his  current  credit  in 
accordance  with  the  enlarged  investment  of  capital. 
On  the  other  hand,  the  banker  may  have  his  own 
reasons  for  thinking  that  such  a  step  will  be  unwise, 
and  by  making  it  plain  to  his  customer  that  the  financ- 
ing of  the  new  enterprise  will  be  attended  with  much 
greater  difficulty  he  may  influence  the  concern  either  to 
provide  enough  capital  to  take  care  of  its  own  current 
financing  or  to  restrict  its  operations,  or  perhaps  seek 
to  transfer  them  to  other  banks,  where  they  may  meet 
with  the  same  kind  of  discouragement  that  has  been 
offered  in  the  first  place.  The  result  of  such  financing 
of  an  institution  is  Hkely  to  be  an  increase  in  conserv- 
atism, the  producers  determining  not  to  go  ahead  faster 
than  they  can  get  assurance  of  credit. 

This  kind  of  careful  study  of  industrial  conditions, 
coupled  with  an  analysis  of  the  position  of  various  kinds 
of  industry,  is  coming  to  be  a  more  and  more  important 
element  in  practical  banking,  and  its  results  are  ha\dng 
a  larger  and  larger  influence  upon  the  direction  and 


BANK  PORTFOLIOS  141 

volume  of  bankers'  loans.  It  is  clear  that  in  so  far  as 
they  operate  to  increase  or  reduce  the  amount  of  loans 
in  any  particular  line,  or  to  shift  funds  from  one 
branch  of  industry  into  another,  they  have  a  very 
important  effect  upon  bank  portfolios.  For  example, 
after  the  armistice  which  closed  the  war  ^^^th  Ger- 
many, many  American  bankers  were  of  the  opinion 
that  the  disturbance  of  European  currencies  was  such 
that  they  could  not  afford  to  assume  commitments  in 
foreign  money.  The  result  was  a  very  general  refusal 
to  discount  foreign  bills  in  the  United  States,  and 
hence  a  great  reduction  in  the  amount  of  such  bills 
actually  appearing  in  the  portfolios  of  the  banks. 
Analysis  of  the  portfolios  of  specified  groups  of  banks 
a  year  after  the  armistice  seemed  to  show  that  these 
banks  were  keeping  themselves  almost  entirely  out  of 
foreign-exchange  commitments.  As  a  matter  of  fact, 
in  this  particular  instance,  the  outcome  was  not  what 
had  been  intended,  for  the  reason  that  the  banks,  at 
the  same  time  that  they  failed  to  discount  foreign  bills, 
allowed  themselves  to  lend  heavily  to  export  houses 
which  carried  their  foreign  customers  on  open  account, 
so  that  the  banks  were  really  engaged  in  financing 
foreign  trade,  after  all.  A  glance,  however,  at  their 
portfolios  indicated  the  important  modification  of  the 
form  of  these  portfolios  which  had  been  effected  at  the 
time  referred  to,  and  illustrates  the  extensive  influence 
that  may  be  exerted  upon  the  classification  and  grouping 
of  banking  assets  by  such  considerations  as  ha\'e  just 
been  referred  to.  It  frequently  happens  that  well- 
informed  bankers  reach  the  conclusion  that  a  given 
industry  is  proceeding  too  fast,  and  that  consequently 
the  instruction  is  given  to  curtail  the  amount  of  invest- 
ment in  the  paper  of  that  industry.  Such  orders 
usually  take  effect  first  of  all  in  the  open  or  com- 
mercial-paper market,  and  the  effect  of  them  is  to 


142  BANKING  AND   BUSINESS 

reduce  the  marketability  of  the  paper  of  the  industry 
in  question.  Such  paper  is  thus  excluded  from  bank 
portfolios  in  a  greater  or  less  degree,  and  the  composi- 
tion of  these  portfolios  is  gradually  altered. 

All  this  may  be  summed  up  in  another  form  of  lan- 
guage by  saying  that  the  loan  policy  or  lending  policy 
of  the  bank  is  one  which  must  be  determined  in  such 
a  way  as  to  maintain  liquidity  and  at  the  same  time  to 
distribute  credit  fairly.  Such  a  policy  must  be  changed 
from  time  to  time  as  the  changing  conditions  demand. 

V.  Government  Restrictions  on  Loans. 

Consideration  has  thus  far  been  given  to  the  methods 
which  a  bank  may  follow  in  establishing  a  sound  port- 
folio. This  policy  is  determined  not  alone  by  the 
judgment  of  the  banker,  but  also  by  a  certain  amount  of 
government  control  which  seeks  to  maintain  the  liquid- 
ity of  banks  in  general.  Government  regulation  of 
loans  takes  the  form  either  of  absolute  prohibition  of 
certain  types  or  of  conditional  restrictions  of  others. 
The  specific  provisions  of  the  National  Bank  Act  are 
designed  to  forbid  the  granting  of  loans  which  imperil 
the  safety  or  liquidity  of  the  bank.  A  national  bank 
is  not  allowed  to  grant  a  loan  collateraled  by  its  own 
capital  stock,  nor  can  it  purchase  its  own  shares  except 
to  prevent  loss  on  debts  previously  contracted.  Real 
estate  may  be  owned  by  a  national  bank  only  if  the 
building  is  used  for  its  own  business  or  if  the  property 
has  been  acquired  through  the  nonpayment  of  debts 
on  the  part  of  borrowers.  The  bank  must  dispose  of 
such  property  acquired  through  default,  for  the  stock 
must  be  sold  within  six  months  and  the  real  estate  in 
less  than  five  years. 

Of  greater  significance  are  the  legal  restrictions  im- 
posed on   loans   granted  by  national  banks.     These 


BANK   PORTFOLIOS  143 

regulations  enter  into  the  daily  transactions  of  every 
national  bank,  and  their  content  should  be  known  by 
business  men  who  receive  loans  as  well  as  by  bankers 
who  grant  them.  These  restrictions  limit  the  various 
classes  of  loans  in  the  following  respects:  (1)  amount 
to  one  party,  (2)  aggregate  amount  of  any  one  class  of 
loans,  (3)  value  of  collateral,  (4)  maturity  of  obligations. 

The  system  of  independent  banking  which  prevails  in 
the  United  States  has  developed  mainly  banks  of  small 
size  and  there  is  frequently  a  tendency  for  single  bor- 
rowers to  receive  loans  entirely  out  of  proportion  to  the 
resources  of  the  lending  institutions.  As  a  result  a 
bank  at  times  holds  an  excessive  amount  of  obliga- 
tions due  from  one  business  enterprise,  and  so  the  wel- 
fare of  the  former  may  become  entirely  dependent  upon 
the  fate  of  the  latter.  The  bank's  safety  can  to  some 
extent  be  insured  through  wider  distribution  of  its 
credit  risks,  and  so  this  policy  is  encouraged  by  legisla- 
tion limiting  the  amount  which  a  bank  may  lend  to 
any  one  person,  firm,  or  corporation.  This  limitation 
is  usually  expressed  in  the  form  of  a  ratio  between  the 
loan  to  the  borrower  and  the  capital  investment  of  the 
bank.  For  example,  the  National  Bank  Act  does  not 
allow  a  loan  to  one  interest  in  excess  of  10  per  cent  of 
the  bank's  paid-up  and  unimpaired  capital  and  surplus. 
By  including  the  surplus  in  this  ratio  a  larger  extension 
of  credit  is  thus  permitted  than  if  capital  alone  were 
taken  as  a  basis. 

Another  set  of  restrictions  is  imposed  not  upon 
the  amount  of  loans  to  single  borrowers,  but  upon 
the  aggregate  amount  of  certain  classes  of  loans  which 
are  limited  to  a  definite  proportion  of  the  bank's 
capital  and  surplus.  The  total  of  such  classes  of  loans 
to  all  borrowers  must  not  exceed  the  entire  amount  of 
the  bank's  capital  and  surplus. 

Another  method  of  enforcing  the  principles  of  safety 


144  BANKING  AND  BUSINESS 

through  government  regulation  is  to  insist  that  a  bank 
in  granting  certain  kinds  of  loans  shall  receive  collateral 
which  offers  an  adequate  margin.  This  value  in  excess 
of  the  loan  will  vary  with  the  character  of  the  col- 
lateral. If  its  marketability  is  restricted,  its  value  is 
necessarily  limited,  and  the  bank  must  protect  itself 
against  loss  by  requiring  a  relatively  larger  margin. 

These  limitations  on  the  lending  powers  of  banks  have 
reference  mainly  to  their  safety,  but  to  insure  their 
liquidity  is  also  essential,  and  therefore  another  form  of 
government  restriction  confines  the  maturity  of  cer- 
tain classes  of  loans  to  specified  periods  of  time.  Con- 
sideration will  now  be  given  to  the  four  classes  of 
restrictions  as  they  are  applied  to  the  following  obliga- 
tions: (1)  promissory  notes,  (2)  acceptances,  (3)  real- 
estate  loans. 

1.  Loans  to  One  Interest. 

Under  the  National  Bank  Act  a  loan  evidenced  by 
an  unsecured  obligation,  whether  promissory  note  or 
bill  of  exchange,  cannot  exceed  10  per  cent  of  a  bank's 
paid-up  and  unimpaired  capital  and  surplus.  This 
fundamental  limitation  was  continued  in  the  Federal 
Reserve  Act,  which,  however,  added  certain  exceptions. 
In  addition  to  the  unsecured  loan,  a  customer  can  also 
receive  another  loan  amounting  to  15  per  cent  of  the 
bank's  capital  and  surplus,  provided  the  note  is  secured 
by  bills  of  lading  and  other  shipping  documents,  ware- 
house receipts,  or  other  instruments  convening  or 
securing  title  to  readily  marketable,  nonperishable 
staples  having  an  actual  market  value  of  115  per  cent 
of  the  face  amount  of  the  note.  Thus  a  bank  \\ith  a 
capital  and  surplus  of  $100,000  may  grant  to  a  customer 
one  loan  of  $10,000  based  on  his  promissory  note. 
Assuming  that  he  has  shipped  a  consignment  of  cotton 
worth  $17,250,  he  may  then  present  the  bill  of  lading, 


BANK   PORTFOLIOS  145 

insurance  polic}',  and  other  shipping  documents  as 
collateral  to  the  bank  and  receive  another  loan  of 
$15,000  on  this  second  promissory  note. 

During  the  recent  war  another  exception  was  made 
to  the  10-per-cent  limitation  of  the  National  Bank 
Act.  In  order  to  encourage  the  sale  of  Liberty  Bonds, 
Victory  Notes,  and  certificates  of  indebtedness,  these 
could  be  used  as  a  means  of  obtaining  additional 
accommodation  from  banks.  Regardless  of  any  other 
loans  which  the  customer  may  have  already  received, 
he  could  obtain  additional  credit  amounting  to  10  per 
cent  of  the  bank's  capital  and  surplus,  if  his  note  were 
secured  by  not  less  than  a  like  amount  of  government 
war  obligations.  Thus  the  bank  mentioned  above,  vriih 
a  capital  and  surplus  of  S100,000,  could  have  loaned  to 
one  customer  the  maximum  sum  of  S35,000  on  the  follow- 
ing three  notes:  (1)  $10,000  on  a  straight  unsecured 
obligation,  (2)  $15,000  collateraled  by  shipping  docu- 
ments or  warehouse  receipts,  (3)  $10,000  secured  by  a 
like  face  amount  of  government  war  obhgations. 

Certain  types  of  loans  are  free  from  any  restriction. 
No  hmit  is  imposed  by  law  upon  loans  which  a  bank 
grants  to  a  customer  on  his  promissory  note  if  it  is 
secured  by  government  war  obligations  whose  face 
value  is  at  least  105  per  cent  of  the  amount  of  the  note. 
This  suspension  of  the  10-per-cent  limitation  was  re- 
garded as  a  necessary  measure  in  financing  the  war,  but 
this  privilege  expired  on  December  31,  1921. 

The  exceptions  so  far  discussed  have  been  applied  to 
loans  evidenced  by  the  promissory  notes  of  the  bank's 
customers.  All  limitations  are  also  waived  on  "bills 
of  exchange  drawn  in  good  faith  against  actua'ly  exist- 
ing values."  These  instruments  are  defined  by  the 
rulings  of  the  Federal  Reserve  Board  as  drafts 
secured  by  a  complete  set  of  shipping  documents 
which  convey  a  clear  title  to  goods  already  shipped  or 


146  BANKING   AND   BUSINESS 

in  process  of  shipment.  Such  bills  of  exchange  also 
include  bankers'  acceptances  eligible  for  rediscount 
under  Section  13  of  the  Federal  Reserve  Act.  The 
bank  is  also  unrestricted  in  extending  credit  to  a  bor- 
rower if  it  discounts  commercial  paper  which  he  has 
received  from  his  customers  in  the  course  of  his  business 
and  actually  owns.  Thus  promissory  notes  or  bills  of 
exchange  which  evidence  debts  due  from  other  persons 
may  be  offered  by  the  borrower  and  discounted  by  the 
bank. 

The  absence  of  any  limitations  on  the  three  types  of 
loans  described  above  has  been  justified  on  the  ground 
that  the  lending  bank  is  given  adequate  protection. 
This  protection  depends  upon  the  following  factors: 

(1)  amount  of  the  margin  or  excess  value  of  collateral, 

(2)  the  value  of  the  business  transaction  on  which  the 
obligation  is  based,  (3)  the  credit  standing  of  two 
parties — maker  in  the  case  of  a  note,  acceptor  in  the 
case  of  a  draft,  and  indorser  of  both  instruments. 

2.  Aggregate  Amount  of  Acceptances. 

The  above  analysis  has  viewed  only  regulations 
limiting  the  amount  of  loans  which  a  bank  may  grant 
to  one  borrower.  Other  restrictions  apply  to  the 
aggregate  liabilities  which  a  bank  may  assume  to  all  its 
customers  in  making  acceptances.  National  banks  were 
first  given  the  right  to  accept  drafts  by  the  Federal 
Reserve  Act.  Under  the  provisions  of  this  statute,  a 
national  bank  may  accept  in  behalf  of  its  customers  bills 
of  exchange  to  a  total  value  of  50  per  cent  of  its  capital 
and  surplus.  This  power  to  accept  drafts  may  be  aug- 
mented to  100  per  cent  of  the  capital  and  surplus  of  the 
bank  if  the  petition  for  this  privilege  is  granted  by  the 
Federal  Reserve  Board.  A  bank  may  accept  drafts 
arising  out  of  transactions  in  foreign  as  well  as  domestic 


BANK  PORTFOLIOS  147 

trade.  While  the  total  of  these  foreign  acceptances 
may  possibly  equal  100  per  cent  of  its  capital  and 
surplus,  or  its  maximum  acceptance  liability,  in  no 
event  may  the  domestic  bills  of  exchange  amount  to 
more  than  50  per  cent.  Acceptances  based  on  foreign 
transactions  may  have  a  maturity  of  six  months, 
but  those  growing  out  of  domestic  business  may  not  run 
longer  than  three  months.  Banks  engaged  in  interna- 
tional trade  financing  may  accept  drafts  to  create  dollar 
exchange  in  certain  foreign  countries,  provided  that  the 
aggregate  of  the  additional  drafts  does  not  exceed 
50  per  cent  of  their  combined  capital  and  surplus,  and 
does  not  have  a  maturity  longer  than  three  months,  or 
one-fourth  of  a  year.  Thus  a  bank  with  a  combined 
capital  and  surplus  of  $1,000,000  may  incur  a  total 
acceptance  liability  of  $1,500,000,  constituted  as  fol- 
lows: (1)  $500,000  on  acceptances  arising  out  of  do- 
mestic transactions,  (2)  $500,000  growing  out  of  foreign 
transactions,  and  (3)  $500,000  on  acceptances  drawn 
to  create  dollar  exchange.  Also,  1  and  2  may  be 
combined  so  that  the  total  of  foreign  acceptances  will 
amount  to  $1,000,000,  or  100  per  cent  of  the  bank's 
capital  and  surplus. 

5.  Real-estate  Loans. 

The  third  class  of  restrictions  is  based  on  loans  secured 
by  real  estate.  Such  security  for  a  loan  \vas  prohibited 
absolutely  under  the  provisions  of  the  National  Bank 
Act,  but  the  Federal  Reserve  Act  removed  this  restric- 
tion by  conferring  the  right  to  grant  such  loans  upon 
all  banks  located  outside  of  the  central  reserve  cities 
of  New  York,  Chicago,  and  St.  Louis.  Real  estate  has 
the  defect  of  possessing  only  a  limited  marketability,  and 
to  prevent  a  bank  from  lending  too  heavily  in  this 
direction   the  Federal    Reserve  Act    imposes   several 


148 


BANKING  AND  BUSINESS 


restrictions  on  these  loans.  Their  aggregate  to  all  bor- 
rowers must  not  exceed  either  25  per  cent  of  the  bank's 
capital  and  surplus,  or  S3}i  per  cent  of  its  time  de- 
posits. In  every  case  the  loan  must  not  be  over  50 
per  cent  of  the  appraised  value  of  the  property.  The 
maturity  is  limited  to  five  years  on  farm  land,  which 
must  be  improved  and  unencumbered,  and  to  one  year 
if  based  on  other  real  estate,  such  as  improved  prop- 
erty. In  order  to  confine  these  loans  to  the  vicinity 
of  the  bank,  the  property  must  be  situated  within  a 
radius  of  one  hundred  miles. 

These  legal  restrictions  on  the  loans  of  national  banks 
may  be  summarized  in  the  following  tables: 


Examples  of  What  a   National  Bank   May  Lend  at  Any 

One  Time  to  Any  One  Customer  Under  the  Ament)- 

MENT  TO  Section  5200,  Approved  October  22,  1919 

Expressed  in  Terms  of  Percentage  of  the 

Bank's    Capital    and    Surplus 


Illustra- 
tion 
1 

Illustra- 
tion 
2 

Illustra- 
tion 
3 

10% 

0% 

5% 

15% 

20% 

15% 

10% 

10% 

15% 

35% 

35% 

35% 

Accommodation    or    straight    loans 
Notes    secured    by    warehouse    re- 
ceipts, etc 

Notes  secured  by  a  like  face 
amount  of  Government  obliga- 
tions     ■ 

Total 

Bills  of  exchange  drawn  against 
actually  existing  values  

Commercial  or  business  paper  .... 

Notes  secured  by  at  least  105% 
of  U.  S.  Government  obligations 


No  limit  imposed  bj'  law. 
No  limit  imposed  by  law. 

No  limit  imposed  by  law. 


BANK  PORTFOLIOS 


149 


Legal  Limitations  on  Loans  by  National  Banks 


Rate 

Character  of  Loans 

Rate 
Per  Cent 
of  Capital 
and  Surplus 
Loanable  to 
One  Interest 

Rate 

Per  Cent 

of  Collateral 

to  Amount 

of  Loan 

Per  Cent 

of  Capital 

and  Surplus 

Loanable  in 

the 

Aggregate 

Maturity  of 
the  Obliga- 
tion in  Terms 
of  Years 

L  Framissory  Notes. 

(a)  straight — un- 

secured   

10 

no  limit 



(h)  secured    by 

warehouse  re- 

ceipts or  ship- 

ping   docu- 

ments  

15 

115 

(c)  secured    by 

government 

war    obliga- 

tions   

(     10 
I  no  limit 

100 

)) 

105 

)» 

2.  Bills  of  Exchange 

(a)  unsecured .  .  . 

10 

(b)  secured    by 

shipping 

documents 

"based    on 

actually    ex- 

isting values" 

— foreign 

transactions. 

no  limit 

100 

K 

domestic 

transactions. 

no  Hmit 

50 

K 

(c)  create    dollar 

exchange .... 

10 

50 

H 

Commercial  or  Busi- 

ness Paper  Owned. 

no  limit 

no  limit 

3.  Real-estate  Loans. 

(a)  fanning  prop- 

erty   

10 

25, 
or33H 

5 

200 

(b)  improved 

of  time 

property .... 

10 

(deposits 

1 

CHAPTER  X 

RESERVES 

I.  Meaning  of  a  Reserve  and  Reserve  Policy. 

In  dealing  with  bank  reserves  thus  far  the  subject 
has  been  spoken  of  as  if  the  reserve  of  a  bank  were  more 
or  less  a  self-regulating  factor  in  its  business.  In 
some  countries,  notably  our  own,  the  law  regulates 
the  amount  of  reserve  which  is  required,  and  in 
others  local  custom  controls  it  in  a  degree  which 
is  quite  as  strict  as  our  legal  requirements.  It  remains 
true  that  the  reserve  of  a  bank  has  a  very  special 
relationship  to  the  position  of  the  bank  itself,  while 
the  reserve  level  or  ratio  is  by  many  persons  taken 
as  an  indication  of  the  strength  of  the  institution. 
Because  of  this  peculiar  position  of  the  bank  reserve 
it  is  worthy  of  special  study  both  from  the  standpoint 
of  theory  and  from  that  of  practice. 

As  has  already  been  seen,  the  reserve  of  a  bank  is 
easily  conceived  of  as  the  ultimate  cash  or  legal  tender 
which  the  bank  holds  for  the  purpose  of  meeting  its 
obligations  which  are  presented  to  it  for  redemption. 
In  most  discussions  of  banking,  therefore,  there  is  quite 
a  distinct  implication  that  a  reserve  is  a  fund  of  cash 
which  is  held  by  the  banker  for  the  purpose  of  making 
payments  on  demand.  Further  study,  however,  shows 
that  this  view  of  the  case,  although  correct  enough 
when  reference  is  had  to  an  individual  bank  which  has 
no  connection  vnih  any  other  institution,  is  hardly 
adequate  if  the  bank  under  consideration  is  a  member  of 
a  system  or  series  of  institutions.     For  example,  under 


RESERVES  151 

the  National  Banking  Act  prior  to  the  adoption  of  the 
Federal  Reserve  Act,  it  was  expressly  provided  that 
three-fifths  of  the  country  bank's  reserves  might  con- 
sist not  of  cash  in  vault,  but  of  deposit  accounts  with 
other  banks.  At  the  present  time  under  the  Federal 
Reserve  Act  cash  in  vault  is  not  legally  counted  as 
reserve,  but  only  the  bank's  balance  on  the  books  of 
the  Federal  Reserve  bank.  True,  the  bank  which 
has  cash  in  hand  can  at  once  convert  it  into  reserve  by 
depositing  it  with  the  Federal  Reserve  bank,  but  8o 
long  as  the  cash  is  held  in  vault  it  is  not  technically 
reserve.  Thus  it  appears  that  under  certain  circum- 
stances the  bank's  reserve  consists  not  of  cash  at  all, 
but  of  credit  with  other  banks. 

In  the  same  way  it  is  evident  that  if  a  bank  possesses 
claims  which  are  cashable  at  sight  it  is  in  as  strong  a 
position  as  if  it  had  actual  cash.  For  example,  if  a 
bank  has  on  an  average  one  million  dollars  of  checks 
presented  to  it  through  the  clearing  house  and  has  no 
offsetting  claims  with  which  to  meet  them,  it  must 
expect  to  see  its  reserve  reduced  by  one  million  dollars. 
If,  however,  it  has  claims  on  other  banks  of  equal 
amount,  the  cashing  of  these  checks  has  no  effect  upon 
its  reserves,  which  remain  the  same.  Here  is  another 
application  of  the  thought  that  interbank  credit  is  fre- 
quently a  satisfactory  form  of  bank  reserve.  How 
this  idea  is  developed  in  the  actual  computation  of 
member  bank  reserves  has  been  elsewhere  explained  in 
connection  with  government  regulation  and  need  not 
be  enlarged  upon  here. 

One  further  development  of  the  reser\'e  idea  needs, 
however,  to  be  noted  before  leaving  this  phase  of  the 
subject.  A  bank  may  have  in  its  possession  paper 
made  by  solvent  institutions,  firms,  or  individuals, 
which  is  not  payable  at  sight  or  on  demand,  but  which 
under  central  bank  arrangements  is  convertible  into  a 


152  BANKING  AND   BUSINESS 

reserve  credit  through  the  process  of  rediscounting.  In 
that  event — assuming  that  the  reserve  institution  stands 
ready  to  rediscount  such  eligible  paper  practically  in 
any  quantity  desired — the  bank  may  be  warranted  in 
regarding  its  holding  of  such  paper  as  in  effect  equiva- 
lent to  reserve.  This  fact  is  expressed  in  the  familiar 
term  which  refers  to  the  "secondary  reserve"  of  a 
bank,  meaning  thereby  items  of  assets  which  can  quickly 
be  converted  into  means  of  payment.  Summing  up, 
we  may  say  that  in  modern  banking  the  bank  reserve 
includes  all  these  parts  of  the  bank's  assets  which  are 
available  for  meeting  demand  obligations.  They  may 
be  actual  cash  in  hand,  or  cash  with  another  bank,  or 
rediscount  credit  on  the  books  of  another  bank,  or 
unquestionably  eligible  items  ready  for  rediscount. 

With  this  understanding  or  definition  of  the  term 
"reserve,"  the  analysis  of  it  becomes  considerably 
easier.  By  a  bank's  reserve  policy  is  meant  the  policy 
of  the  bank  in  dividing  its  assets  between  quicker  and 
long-term  obligations.  A  bank's  reserve  is  low  when 
the  bulk  of  its  funds  are  in  obligations  which  cannot  be 
realized  for  some  time  to  come.  It  is  high  when  the 
proportion  of  its  assets  in  immediately  available  form 
is  large.  The  "reserve  ratio"  which  is  often  spoken 
of  with  reference  to  banks  is  obtained  by  dividing  the 
quantity  of  actual  cash  or  available  bank  credit  which 
the  institution  owns  by  the  amount  of  its  demand 
liabilities.  Thus,  for  instance,  if  bank  A  has  on  its 
books  $100,000  of  demand  deposits  and  has  outstanding 
$50,000  of  notes,  it  may  evidently  be  called  upon  at 
any  time  to  pay  $150,000.  Now,  if  this  bank  has  in  its 
vaults  $75,000  in  cash,  it  has  a  reserve  of  50  per  cent. 
If,  under  the  Federal  Reserve  system,  it  has  $75,000 
credited  to  it  by  its  Reserve  bank,  it  has  a  reserve  of 
50  per  cent.  In  the  case  of  the  Reserve  bank  itself, 
only  the  cash  on  hand  is  figured  in  estimating  reserves. 


RESERVES  153 

In  order  to  keep  a  bank  solvent  it  must  evidently 
maintain  in  available  or  liquid  form  such  a  part  of  its 
assets  as  \vi\\  under  any  probable  conditions  enable  it 
to  meet  the  demands  that  may  be  presented  to  it. 
These  may  be  notes  offered  for  cashing,  or  checks  dra^sTi 
upon  it  by  depositors  and  presented  by  other  banks. 
Exactly  how  large  a  proportion  of  such  demands  will  be 
presented  at  any  time  is  a  matter  which  can  be  deter- 
mined only  by  experience.  The  Federal  Reserve  Act  re- 
quires central  reserve  city  banks  to  keep  a  reserve  of  13 
per  cent  against  their  demand  deposits  with  Federal  Re- 
serve banks,  but  it  is  assumed  that  the  banks  will  main- 
tain in  their  portfolios  a  considerable  additional  amount 
of  eligible  paper  which  may  be  rediscounted  at  any  time. 
Before  the  Federal  Reserve  Act  was  adopted,  such  banks 
were  required  to  keep  in  their  own  vaults  a  cash  reserve 
of  25  per  cent.  In  the  central  banks  of  Europe,  prior 
to  the  outbreak  of  the  war,  it  was  not  infrequent  to 
carry  reserves  ranging  from  60  to  70  per  cent  of  demand 
liability.  Yet  in  England  the  joint-stock  banks  fre- 
quently allowed  their  reserves  of  cash  in  vault  to  run 
below  5  per  cent  of  demand  liabilities,  trusting  to  re- 
plenish them,  if  necessary,  through  credit  obtained  at 
the  Bank  of  England.  From  all  this  it  is  clear  that 
there  is  great  variation  between  different  banks  in  re- 
gard to  the  amount  of  reserve  needed  or  called  for,  and 
that  the  amount  thus  required  depends  a  great  deal 
upon  the  character  of  the  bank's  business  and  the 
attitude  of  its  clientele  at  any  time.  Maintenance  of  a 
proper  amount  of  reserves  is  thus  the  outcome  of 
knowledge  on  the  pai't  of  the  banker  concerning  the 
needs  of  his  community,  and  in  no  small  measure  the 
result  of  experience  and  observation  of  local  habits  and 
customs.  A  much  larger  reserve,  for  example,  must 
be  carried  in  a  factory  town  where  large  numbers  of 
employees  are  paid  off  on  Saturday  night,   than  is 


154  BANKING  AND   BUSINESS 

necessary  in  a  neighboring  residential  suburb  where 
there  is  httle  demand  for  cash  and  where  payments 
are  largely  made  by  check. 

II.  Maintenance  of  Reserve. 

Supposing,  however,  that  a  banker  has,  through 
experience,  guided  by  legislative  requirements,  deter- 
mined the  approximate  amount  of  reserve  which  he 
needs  to  carry  in  ordinary  circumstances,  it  will  be  a 
matter  of  constant  watchfulness  on  his  part  to  see  that 
he  is  able  to  maintain  the  proper  balance  between  quick 
and  slow  assets.  If,  for  example,  a  number  of  his  cus- 
tomers are  obliged  to  ask  for  extensions  of  credit,  he 
does  not  receive  payments  either  in  the  form  of  checks 
on  other  banks  or  cash  or  of  reduction  of  his  own  out- 
standing liabilities  that  he  may  have  counted  upon. 
He  thus  finds  that  his  liabilities  are  larger  than  he  had 
expected  in  proportion  to  his  quick  assets.  On  the 
other  hand,  if  he  is  too  conservative  he  may  find  that 
he  misses  much  good  business  by  holding  his  customers 
to  too  short  a  period  of  credit,  thus  obliging  them  to  go 
to  Qther  banks  which  are  more  liberal,  although  he 
might  with  reasonable  safety  have  carried  such  paper 
in  his  portfolio.  Good  banking  alwaj^s  provides  an 
adequate  means  of  liquidating  claims,  but  profitable 
banking  prevents  these  means  from  becoming  and 
growing  into  a  dead  weight  upon  the  institution  as  the 
outgroAvth  of  undue  conservatism. 

If,  however,  as  often  happens,  a  community  becomes 
involved  in  long-term  credit  operations  and  a  given 
bank  has  allowed  itself  to  undertake  operations  that 
are  really  beyond  its  strength,  the  result  is  a  tendency 
to  cut  down  the  available  short-term  assets  and 
especially  the  cash  or  credit  available  for  pajTiients, 
with  the  consequence  that  some  means  must  be  found 


RESERVES  155 

of  restoring  them.  Every  banker  has  at  times  to  con- 
template the  necessity  of  employing  these  means.  In 
general  it  is  a  choice  between  the  following  courses  of 
action : 

1.  To  suspend  or  refuse  further  applications  for 
credit  from  customers; 

2.  To  discourage  customers  by  raising  his  rate  of 
discount  in  such  a  measure  as  to  drive  away  the  less 
necessary  applications ; 

3.  To  discount  some  of  his  paper  with  another  bank 
or  to  sell  to  that  bank  a  part  of  his  assets; 

4.  To  purchase  or  acquire  specie,  perhaps  abroad,  or 
in  unusual  cases  at  home,  paying  for  it  in  securities  or 
long-term  assets,  and  in  return  receiving  a  shipment  of 
actual  coin  or  currency. 

All  of  these  methods  are  at  times  employed  by 
bankers  in  the  process  of  restoring  depleted  reserves. 
The  question  which  method  to  employ  and  how  to 
employ  it  is,  however,  a  problem  which  involves  the 
full  issue  of  sound  and  careful  banking  management. 

1.  Refusal  of  Further  Credit  Accommodation. 

If  the  banker  resorts  to  the  plan  of  refusing  to  accom- 
modate his  customers  merely  because  his  reserves  have 
fallen  below  a  desired  limit,  he  has  cut  these  customers 
off  from  credit  which  may  be  absolutely  essential  to 
their  continuance  in  business.  He  has  thus  taken  a 
step  of  very  serious  character  and  one  which  can  hardly 
be  warranted  save  under  the  absolute  necessity  of 
preserving  the  integrity  of  his  own  institution  or  of 
meeting  the  demand  obligations  which  he  has  already 
outstanding.  The  banker's  first  duty,  not  merely  to 
himself  and  his  stockholders,  but  to  the  community,  is 
that  of  keeping  open  his  doors  and  meeting  all  demands 
upon  him  as  presented.  Everything  else  must  be 
subordinated  to  this.     It  is  a  more  or  less  secondary 


15G  BANKING  AND   BUSINESS 

matter  that  the  bank  is  thoroughly  solvent  and  that 
the  depositors  will  eventually  be  paid  in  full. 

If  the  bank  once  closes,  general  confidence  has  been 
correspondingly  impaired,  and  if  the  bank  remains 
closed  all  of  its  depositors  are  deprived  of  the  immediate 
use  of  funds  upon  which  they  have  been  relying  to 
protect  themselves.  This  may  cause  absolute  disaster 
to  them,  especially  if  they  are  not  able  easily  to  open 
new  banking  connections,  as  they  probably  will  not  be. 
Therefore  it  is  clear  that  there  may  be  times  when  the 
absolute  refusal  of  further  credit  by  the  banker  in 
order  to  protect  what  is  left  of  his  reserve  and  enable 
him  to  meet  the  claims  of  depositors  and  others  is 
essential.  This,  however,  will  be  the  unusual  case,  and 
indeed  it  is  often  true  that  the  refusal  of  loans  by  a 
banker  gives  a  perhaps  unwarranted  impression  of 
weakness  on  his  part,  with  the  result  of  destroying 
confidence  and  starting  "runs"  which  may  wreck 
even  a  very  strong  and  well-protected  institution. 

2.  Advance  of  Discount  Rate. 

In  lieu,  therefore,  of  refusing  credit,  it  is  customary 
with  bankers  to  advance  the  rate  of  discount  for  the 
purpose  of  inducing  the  less  necessary  credit  applica- 
tions to  be  withdrawn.  The  plan  in  ordinary  cir- 
cumstances is  quite  successful,  since  there  are  always 
applicants  who  are  on  the  margin  of  doubt  whether  to 
borrow,  or  at  all  events  whether  to  borrow  as  freely 
as  they  are  inclined  to  do.  Such  applicants  are  dis- 
couraged by  the  high  rate  of  discount,  which  takes  the 
profit  out  of  the  "marginal"  element  of  their  business, 
and  when  rates  are  high  and  conditions  of  borrowing 
stringent  they  are  likely  to  limit  their  operations.  In 
very  acute  conditions  of  crisis  or  stringency,  however, 
there  is  less  doubt  whether  the  apphcation  even  of  a 
rather  high  rate  of  discount  vnH  be  successful.     The 


RESERVES  157 

idea  of  rationing  credit — that  is,  of  investigating  the 
purpose  for  which  appHcations  are  made  and  of  grant- 
ing only  those  that  are  definitely  necessary — is  fre- 
quently resorted  to  as  a  modification  of  the  plan  first 
suggested — the  absolute  suspension  or  refusal  of 
further  accommodation.  It  may  be  said,  however, 
that  the  banker's  duty  is  that  of  continuing  to  accom- 
modate his  customers  even  in  times  when  his  reserve 
is  being  seriously  infringed  upon,  and  that  the  very 
purpose  of  the  reserve  itself  is  to  enable  him  to  con- 
tinue extending  this  kind  of  accommodation — that  this 
is,  in  fact,  its  highest  function,  cash  being  kept  on  hand 
for  the  very  purpose  of  dealing  with  unusual  calls  for  aid. 

3.  Rediscount  of  Paper  or  Sale  of  Assets. 

So  clearly  is  this  obligation  recognized  by  most 
bankers  that  they  \\'ill  not  usually  refuse  credit  or  even 
attempt  to  ration  it  in  too  narrow  a  way  unless  there 
is  very  good  reason  for  doing  so,  but  instead  of  resorting 
to  such  a  method  of  restriction  will  ordinarily  resort 
to  the  process  known  as  rediscounting.  Under  condi- 
tions in  which  the  rediscounting  process  is  purely 
■\'oluntary — that  is,  in  which  it  grows  out  of  an  ordinary 
business  relationship  between  banks — it  may  not  be  as 
reliable  a  means  of  relief  as  is  necessary  to  meet  the 
situation.  In  those  countries  where  central  banking 
exists,  or  where,  as  in  the  Federal  Reserve  system, 
there  is  a  co-operative  union  of  banks  whose  purpose  is 
primarily  that  of  mutual  accommodation,  the  case  is 
quite  different.  Such  central  or  co-operative  banks 
have  the  definite  duty  of  relieving  other  Imnks  through 
rediscounting,  and  if  they  are  well  managetl  they  have 
endeavored  to  conserve  their  resources  throughout  ^\'ith 
that  purpose  in  mind.  They  are,  therefore,  in  position 
to  rediscount — to  help  the  bank  which  ap}:)lies  to  them 
by  giving  it  credit  upon  its  own  paper  with  the  indorse- 


158  BANKING  AND   BUSINESS 

ment  of  the  applying  bank.  The  central  bank  does  for 
the  individual  bank  what  the  individual  bank  does  for 
its  customers,  and  does  it  at  a  time  when  the  individual 
banker  needs  funds.  It  thus  enables  the  individual 
banker  to  avoid  the  necessity  of  rationing  or  restricting 
credit,  although  ordinarily  rates  of  discount  are  so 
stated  that  the  rediscounting  process  implies  an 
element  of  greater  cost  or  expense,  which  results  in  the 
raising  of  the  rate  to  the  would-be  borrower. 

Alternative  with  the  idea  of  rediscount  is  that  of 
disposal  of  assets.  The  banker  may  have  carried  in  his 
portfolio,  say,  some  government  certificates  of  indebt- 
edness or  Liberty  Bonds,  and  these  he  may  sell  outright 
in  order  to  realize  cash  when  the  necessity  comes.  In 
this  case  he  employs  exactly  the  same  method  that  was 
used  when  he  rediscounted,  except  that  instead  of 
resorting  to  another  bank  he  goes  to  the  open  market 
for  what  he  needs. 

4-  Purchase  of  Specie. 

Under  some  circumstances  the  demand  on  banks 
may  be  such  as  to  necessitate  a  more  drastic  operation 
than  that  of  rediscounting.  It  may  be  necessary  to 
acquire  or  purchase  specie  by  importing  it.  For  in- 
stance, assume  that  a  country  has  for  a  long  time  been 
suffering  from  an  adverse  balance  of  trade  which  has 
exhausted  its  specie  stock.  As  a  result  we  may  sup- 
pose the  specie  reserves  of  all  banks  in  the  country  have 
become  very  low.  A  stringency  developing  or  severe 
demand  for  cash  continuing,  the  prospect  is  that  some 
or  all  of  the  banks  may  find  their  specie  stock  ex- 
hausted, with  the  result  that  a  suspension  of  specie 
payments  by  common  consent  may  be  necessary;  or, 
lacking  this,  that  some  banks  will  be  unable  to  main- 
tain specie  payments  and  unable  to  obtain  more 
specie  from  other  banks,  so  that  they  will  fail,  with 


RESERVES  159 

the  injurious  results  to  be  expected  from  such  action. 
In  these  circumstances  it  is  necessary  for  the  banking 
system  of  the  country  as  a  whole  to  get  aid  from 
abroad,  and  it  may  do  so  either  by  disposing  of  se- 
curities to  foreign  investors,  or  by  rediscounting  some 
of  its  own  paper  in  foreign  countries,  or  by  protecting 
the  foreign  banks  in  any  other  way  that  will  induce 
them  to  transfer  a  part  of  their  specie,  ^^'hen  such  . 
specie  has  been  received  the  banks  obtaining  it  have 
correspondingly  strengthened  themselves  and  are  in 
a  position  to  proceed  with  their  business  upon  a  con- 
servative basis,  meeting  their  obligations  as  requested 
by  their  customers  and  granting  new  accommodation 
moderately  to  those  who  require  it. 

This  is  a  kind  of  international  rediscount  process 
which  involves  the  transfer  of  specie.  In  ordinary 
domestic  rediscounting  no  such  transfer  is  necessary 
because  the  country  within  which  the  operation  takes 
place  is  operating  upon  a  single  uniform  standard  of 
value,  and  a  credit  granted,  say,  in  New  York  is  easily 
made  available  in  Texas.  The  case  is  different  when 
a  transaction  of  the  kind  occurs  between  two  inde- 
pendent banking  systems  which  operate  upon  a 
different  currency  basis,  so  that  an  actual  shift  of  re- 
sources from  one  to  another  is  necessary.  Something 
of  this  kind  is  seen  in  the  Federal  Reserve  system  at 
times  of  stringency.  Under  the  Federal  Reserve  Act, 
provision  has  been  made  whereby  one  Federal  Reserve 
bank  which  finds  its  reserve  running  down  is  enabled 
to  rediscount,  through  the  Federal  Reserve  Board, 
with  other  Reserve  banks.  The  effect  of  the  redis- 
count is  to  transfer  gold  from  the  account  of  the  bank 
granting  the  rediscount  to  the  account  of  the  bank 
applying  for  it,  thus  cutting  the  rcser\-c  of  the  granting 
bank  and  increasing  the  reserve  of  the  applying  bank. 
This,  as  will  be  ai)parent  to  students  of  banking  theory, 


160  BANKING  AND   BUSINESS 

cuts  down  the  volume  of  further  credit  supply  in  some 
parts  of  the  country  and  increases  it  in  others.  The 
outcome  is  to  readjust  the  specie  resources  and  the  out- 
standing banking  credit  of  the  different  parts  of  the 
country,  and  so  to  bring  about  a  better  and  fairer 
balance  between  them.  The  method  is  analogous  to 
the  process  of  acquiring  specie  by  importing  it,  which 
is  resorted  to  when  one  country  goes  to  the  banks  of 
another  for  help. 

III.  Inflation  and  Deflation. 

In  studying  the  reserve  policy  of  banks  it  is  worth 
while  to  devote  some  attention  to  what  is  called  infla- 
tion and  deflation.  By  the  former  term,  when  used  in 
banking  discussion,  is  meant  the  undue  or  dispropor- 
tionate increase  of  bank  credit.  By  deflation  may  be 
meant  either  the  curtailment  or  destruction  of  inflation, 
or  the  term  may  be  used  to  mean  the  reduction  of 
bank  credit  below  the  normal  permanent  level.  How  is 
it  that  inflation  grows  up,  and  what  is  its  relation  to  the 
reserve  question?  Suppose  the  existence  of  a  bank  which 
stands  alone  in  its  community,  and  which  is  maintain- 
ing a  safe  business  with  a  reasonable  balance  between 
income  and  outgo.  We  may  assume  that  this  bank 
has  on  hand  at  all  times  a  reserve  fund  of  25  per  cent  of 
demand  deposits.  This  bank  has  many  calls  upon  it 
from  customers  about  whose  operations  it  feels  some 
doubt.  It,  however,  becomes  gradually  more  liberal  and 
makes  a  considerable  number  of  loans  which,  although 
well  secured,  are  not  paid  at  maturity,  but  are  renewed. 
The  effect  is  to  increase  the  deposit  line  of  the  bank 
and,  relatively  speaking,  to  decrease  its  reserve  balance. 
For  example,  it  may  be  supposed  that  on  July  1  of  a 
certain  year  the  bank  has  outstanding  $500,000  of 
deposits  and  has  $500,000  of  customers'  notes,  of  which, 


RESERVES  161 

let  us  say,  S50,000  are  frilling  due.  Of  the  makers  of 
this  $50,000  of  paper,  however,  one-half,  represented  by 
$25,000,  ask  for  renewal.  The  bank,  however,  has  to 
meet  on  the  1st  of  July  obligations  of  one  kind  or 
another  which  require  850,000  cash.  Evidently  if  it  ob- 
tained the  payment  of  the  $50,000  of  notes  it  might 
cut  down  its  deposits  to  $450,000  or  might  meet  the 
obligations  presented  by  the  use  of  the  payments  made 
to  it.  In  the  one  case,  its  position  would  be  stronger 
than  ever  because  it  would  have  its  25-per-cent  reserve 
(25  per  cent  of  $500,000)  intact,  though  it  would  have 
cut  its  discount  line  to  $450,000.  But  the  bank,  we  may 
assume,  yields  to  demands  for  renewal  to  the  extent  of 
$25,000  and  hence  has  to  lose  $25,000  in  cash.  Here  it 
has  increased  its  deposit  liability  relatively  to  reserve 
in  order  to  extend  a  longer  credit  to  its  customers. 
When  this  kind  of  operation  occurs  on  an  increasing 
basis,  and  especially  when  it  occurs  as  the  result  of 
loans  made  by  the  banks  upon  long-term  securities  such 
as  bonds,  mortgages,  stocks,  etc.,  and  not  as  a  result 
of  commercial  transactions,  the  result  is  usually  de- 
scribed as  an  inflation  of  bank  credit.  The  effect  of  it 
may  be  in  some  instances  to  cause  an  increase  of  prices 
through  the  action  of  the  owners  of  the  deposit  accounts 
in  demanding  goods  for  which  they  pay  in  checks  on  the 
bank.  If  there  has  been  no  corresponding  enlargement 
of  the  amount  of  goods  in  the  community,  and  if  the 
goods  thus  bought  with  bank  credit  are  unproductively 
employed,  the  result  is  to  decrease  the  amount  of  goods 
in  the  community  relatively  to  purchasing  media,  and 
the  tendency  toward  an  upward  movement  of  prices  is 
then  evident.  In  such  a  case  we  have  what  is  called 
price  inflation,  and  in  the  instance  cited  such  price 
inflation  may  be  more  or  less  directly  associated  with 
bank-credit  inflation.  This  situation  evidently  touches 
closely  upon  the  reserve  condition,   since  the  latter 


162  BANKING  AND   BUSINESS 

usually  acts  as  a  kind  of  barometer,  indicating  when 
the  outstandings  of  the  bank  are  Uquid.  If  the  reserve 
ratio  falls  off,  showing  that  the  supply  of  cash  on  hand 
is  smaller  as  compared  with  outstanding  deposits,  that 
may  be  due  to  inflationary  operations  on  the  part  of 
the  bank.  While  this  is  not  always  true,  it  is  likely  to 
be  so  when  the  decline  in  reserve  occurs  over  a  large 
area  or  group  of  banks  or  at  a  central  bank.  Such  a 
decUne  is  then  in  fact  an  index  of  inflation,  and  it 
usually  follows  that  such  inflationary  conditions  are 
associated  with  a  rise  of  prices. 

Deflation  is  a  word  less  frequently  heard  than  infla- 
tion, but  is  correlative  with  the  latter  term.  As  em- 
ployed in  banking  it  means  the  elimination  from  bank 
portfohos  of  loans  which  have  been  made  on  an  unduly 
long  or  unquestionably  investment  basis.  It  should  be 
remarked  at  this  point  that  the  line  of  distinction  be- 
tween sound  or  normal  bank  loans  and  those  which  are 
inflationary  in  whatever  degree  is  not  absolute,  but 
the  result  of  experimental  observation  in  any  particular 
circumstances.  It  is  a  matter  which  calls  ordinarily  for 
a  discriminating  study  before  positive  conclusions  can 
be  reached  in  any  given  case.  Generally  speaking,  defla- 
tion, however,  is  usually  employed  as  a  term  which 
denotes  the  restoration  of  a  safe  or  satisfactory  balance 
between  outstanding  demands  upon  banks  and  their 
reserve  protection.  In  countries  which  are  organized 
on  a  central  banking  system  this  process  of  deflation 
may  involve  the  reduction  of  rediscounts  carried  by 
commercial  banks  \\ath  the  central  reserve  bank.  In 
such  circumstances  there  is  ordinarily  a  decline  in  the 
bin  holdings  of  the  central  reserve  bank,  and  at  the  same 
time  a  decline  in  the  assets  and  deposits  of  the  rank 
and  file  of  the  banks.  The  result  of  deflation  is  thus  to 
leave  a  smaller  amount  of  credit  at  the  disposal  of  the 
public  as  measured  in  doflars.  It  should  be  remembered, 


RESERVES  163 

however,  that  the  significance  of  inflation  or  deflation 
is  found  primarily  in  connection  with  the  price  level. 
For  instance,  if  with  the  price  level  denoted  by  about 
100  there  is  in  existence  one  million  units  of  bank 
credit,  it  may  be  roughly  true  that  a  decline  in  the  price 
level  to,  say,  50  would  permit  a  decline  in  the  number 
of  credit  units  employed  to  five  hundred  thousand 
without  causing  any  relatively  lessened  use  of  bank 
credit.  Of  course  it  should  be  remembered  that  it 
would  be  rarely,  if  ever,  true  that  any  such  close  arith- 
metic correspondence  as  is  indicat-ed  by  these  figures 
could  be  established  between  credit  and  the  volume  of 
business,  but  the  general  trend  would  be  in  the  direction 
suggested. 

Inflation  and  deflation  are  therefore  relative  terms 
which  can  have  a  direct  meaning  only  in  comparison 
with  price  levels.  Since  bad  banking  or  inflation  itself 
reacts  upon  a  price  level,  a  rather  complex  problem  is 
presented  at  any  given  moment  in  the  effort  to  ascer- 
tain how  far  inflation  has  proceeded  beyond  the  amount 
indicated  by  prices.  So  also  in  the  case  of  deflation  it 
is  difficult  to  decide  at  any  moment  whether  there  is  a 
"shortage  of  credit"  or  whether  what  has  happened  has 
been  merely  the  diminution  of  the  aggregate  number  of 
units  of  credit  rendered  possible  by  the  decline  in  prices 
followed  by  a  lessened  demand  for  credit  to  carry  goods. 

This  whole  subject  may  be  summed  up  in  broad  terms 
by  saying  that  there  is  at  any  given  moment  a  general 
level  of  prices  which  has  been  determined  by  a  com- 
parison between  goods  on  the  basis  of  their  relative 
values  as  expressed  in  terms  of  money.  Departures 
from  this  level,  either  above  or  below,  may  be  due  to 
any  one  or  several  of  a  number  of  factors  working  upon 
the  price  level.  When  a  change  in  the  method  of  grant- 
ing credit  operates  as  such  a  factor  the  result  is  spoken 
of  as  inflation  or  deflation,  as  the  case  may  be. 


CHAPTER  XI 

THE   BANK  STATEMENT 

I.  Significance  of  a  Bank  Statement. 

Consideration  has  been  given  in  preceding  chapters 
to  such  commercial  bank  operations  as  the  receiving  of 
deposits  and  the  granting  of  loans.  These  transactions 
are  all  recorded  in  the  general  ledger  of  the  bank.  A 
summary  of  these  records  is  of  value  to  the  bank  officers, 
government,  and  the  public,  and  so  from  the  general 
ledger  there  is  compiled  a  trial  balance  sheet  known 
as  the  bank  statement. 

The  Comptroller  of  the  Currency,  and  also 
state  superintendents  of  banking,  periodically  de- 
mand statements  to  aid  the  government  in  super- 
vising banking  institutions.  Every  national  bank  is 
required  by  law  to  insert  its  statement  in  the  local  press 
at  regular  intervals  throughout  the  year,  and,  in  fact, 
this  notice  appears  quite  frequently  for  its  own  pub- 
licity value.  These  advertisements  present  a  systematic 
and  classified  tabulation  of  assets  and  liabihties,  and 
prospective  depositors  may  thus  judge  the  solvency  of 
the  bank.  A  report  of  the  previous  day's  business  may 
guide  the  bank's  officers  in  determining  such  poUcies 
as  the 'granting  of  new  loans  and  the  renewal  of  old 
notes.  Banks  in  general  are  also  interested  in  the 
statements  of  other  institutions,  for  interbank  borrow- 
ing is  conducted  on  an  extensive  scale.  In  closing  this 
chapter,  consideration  will  be  given  to  the  way  in 
which  banks  analyze  the  statements  of  other  banks 
which  are  seeking  loans. 


THE   BANK   STATEMENT  165 

The  daily  statement  by  itself  has  only  a  limited  sig- 
nificance. It  presents  merelj^  a  static  picture  of  the 
bank's  condition  on  a  particular  day,  and  should  be 
compared  with  previous  reports  to  study  the  true  finan- 
cial history  of  the  bank  for  the  purpose  of  analyzing 
the  trend  in  deposits,  loans,  and  other  items.  The 
statements  of  a  particular  bank  have  added  interest 
when  viewed  in  relation  to  those  of  other  institutions. 
Such  reports  are  combined  in  several  forms.  The  large 
clearing  houses  compile  weekly  statements  showing  the 
financial  status  of  their  members,  while  the  Federal 
Reserve  banks  and  Federal  Reserve  Board  report  on  a 
selected  Ust  of  member  banks.  The  Comptroller  of 
the  Currency  as  well  as  the  state  superintendents  issue 
annual  summaries  presenting  the  condition  of  banks 
throughout  the  country,  as  shown  by  the  returns  of  the 
examiners  and  the  statements  of  the  banks.  These 
publications  offer  an  excellent  basis  for  interpreting 
general  financial  tendencies. 

The  present  chapter  deals  with  the  statement  of  an 
individual  commercial  bank.  Its  report  as  usually  pre- 
sented in  the  daily  newspaper  does  not  contain  suffi- 
cient details  for  a  complete  analysis,  and  so  the  items 
as  given  in  the  form  for  national  banks  used  by  the 
Comptroller  of  the  Currency  will  serve  as  a  basis. 

II.  Assets  of  the  Bank. 

The  assets  or  resources  are  composed  of  all  the  items 
which  are  in  possession  of  or  due  to  the  bank,  and  it 
relies  upon  these  assets  to  meet  the  liabilities  which  it 
owes  to  others. 

Loans  and  Discounts.  These  include  the  amount 
of  credit  extended  by  the  bank  to  its  customers. 
These  obligations  are  in  the  form  of  promissory  notes 
or  accepted  drafts.     They  may  be  secured  by  stocks, 


166  BANKING  AND   BUSINESS 

bonds,  and  other  collateral,  or  based  merely  on  the 
credit  standing  of  the  makers,  acceptors,  or  indorsers. 
Some  of  these  advances  are  payable  on  demand  and 
so  may  be  called  for  payment  whenever  the  bank  is 
in  need  of  funds.  In  addition  to  loans  extended  to 
customers,  the  bank  also  grants  credit  to  outside  firms 
in  buying  their  commercial  paper  on  the  open  market. 
These  claims  are  sometimes  entered  separately  as  "bills 
purchased." 

Overdrafts.  These  may  be  regarded  as  loans  obtained 
from  the  bank,  usually  without  security,  interest,  or 
consent.  An  overdraft  occurs  when  a  customer  writes 
a  check  to  an  amount  which  exceeds  the  sum  credited 
to  his  account.  The  amount  paid  by  the  bank  in 
excess  of  the  customer's  balance  is  known  as  an  over- 
draft. It  is  evidenced  merely  by  an  entry  in  the 
books  of  the  bank,  but  not  in  a  note  or  other  formal 
instrument.  National  banks  are  prohibited  from 
voluntarily  allowing  overdrafts  to  their  customers. 

Customers^  Liability  under  Letters  of  Credit  and  on 
Account  of  Acceptances.  Foreign  trade  is  financed 
largely  through  drafts  drawn  on  banks  which  accept 
them  in  behalf  of  their  customers.  They  in  turn  assure 
their  bank  that  it  will  be  fully  reimbursed  before  the 
acceptances  fall  due.  The  obligation  to  reimburse  is 
expressed  either  in  the  form  of  contracts  for  letters  of 
credit  or  acceptance  agreements  which  clearly  define 
the  liability  of  the  customers  to  the  bank.  This 
account  is  therefore  an  offset  to  the  item  "letters  of 
credit  and  acceptances  outstanding"  of  the  bank's 
liabilities. 

United  States  Bonds  and  Certificates  of  Indebtedness. 
The  bank  is  required  to  invest  in  certain  classes  of 
United  States  bonds  if  it  wishes  to  issue  its  notes  for 
circulation.  It  is  also  compelled  to  hold  either  of 
these  classes  of  obligations  as  security  for  deposits 


THE   BANK   STATEMENT  1G7 

which  the  United  States  government  carries  with  the 
bank.  States  and  municipaUties  also  require  banks 
acting  as  depositories  to  hold  government  issues  as 
security.  In  addition,  banks  voluntarily  invested  in 
Liberty  Bonds  and  Victory  Notes,  during  the  war, 
because  of  patriotic  motives,  and  have  continued  to 
hold  these  obligations  because  of  their  ready  market- 
ability. 

Bonds,  Securities,  etc.,  Other  Than  United  States. 
These  items  are  held  by  a  bank  as  outright  investments 
or  as  acquisitions  resulting  from  nonpayment  of  loans 
for  which  these  securities  have  served  as  collateral. 

Stocks,  Other  Than  Federal  Reserve  Bank  Stock. 
These  stocks  have  also  been  obtained  from  borrowers 
defaulting  in  their  obligations.  National  banks  are 
forbidden  directly  to  purchase  stocks  because  of  the 
instability  of  their  value.  National  banks  may,  how- 
ever, purchase  a  certain  amount  of  stock  of  corpora- 
tions engaged  in  foreign  banking. 

Stock  of  the  Federal  Reserve  Bank.  Each  member  of 
the  Federal  Reserve  system  must  subscribe  to  the  stock 
of  the  Reserve  bank  of  its  district  to  an  amount  equaUng 
6  per  cent  of  its  own  capital  and  surplus,  but  only  one- 
half  of  this  sum  has  been  called  by  the  Federal  Reserve 
Board. 

Banking  House,  Furniture  and  Fixtures.  These  items 
represent  the  general  equipment  of  the  bank. 

Real  Estate  Owned  Other  Than  Banking  House.  As  a 
commercial  bank  is  obliged  to  pay  most  of  its  deposits 
on  demand,  its  investments,  in  turn,  must  have  short 
maturity.  A  national  bank  is  therefore  not  allowed  to 
purchase  real  estate  for  any  other  purpose  than  actual 
use  in  conducting  its  business.  At  times  it  is  forced 
to  accept  real  estate  pledged  for  loans  on  which  the 
borrowers  have  defaulted. 

Due  from  Branches.     Subject  to  limitations,  banks 

12 


1C8  BANKING  AND   BUSINESS 

may  conduct  domestic  and  foreign  branches  which  thus 
represent  a  certain  amount  of  invested  capital. 

Lawful  Reserve  with  the  Federal  Reserve  Bank.  This 
represents  the  balance  which  the  bank  carries  with  the 
district  Federal  Reserve  bank  for  the  purpose  of  main- 
taining the  required  reserve  against  deposits. 

Items  with  Federal  Reserve  Bank  in  Process  of  Col- 
lection. This  account  includes  checks,  drafts,  and  other 
items  which  have  been  remitted  to  the  district  Federal 
Reserve  bank  for  collection.  From  one  to  eight  days 
are  allowed  for  the  collection  and  payment  of  items 
drawn  on  any  locality  in  the  United  States,  and  in 
accordance  with  this  time  schedule  each  Federal 
Reserve  bank  credits  the  account  of  its  members  with 
the  amount  of  items  left  for  collection.  Thus  all  items 
in  process  of  collection  are  really  deferred  credits  w^ith 
the  Federal  Reserve  bank,  and  only  when  paid  become 
cash  credits  or  lawful  reserve. 

Cash  in  Vault.  A  bank  needs  a  certain  amount  of 
till  money  to  cash  the  checks  of  customers  and  to  meet 
their  current  demands,  such  as  for  pay-roll  purposes. 

Net  Amount  Due  from  Other  Banks,  Bankers,  and 
Trust  Companies.  These  institutions  are  correspond- 
ents collecting  out-of-town  items  not  forwarded  through 
the  agency  of  the  Federal  Reserve  system.  A  bank 
usually  carries  a  deposit  balance  with  each  corre- 
spondent, which  credits  the  account  when  collection 
items  are  actually  paid. 

Exchanges  for  the  Clearing  House.  These  will  be  pre- 
sented for  payment  to  the  other  members  of  the  clear- 
ing house  on  the  following  morning. 

Checks  on  Other  Banks  in  the  Same  City.  As  not  all 
banks  belong  to  the  clearing  house,  checks  drawn  on 
these  institutions  must  be  presented  through 
messengers. 

Redemption  Fund  with  the  Treasurer  of  the  United 


THE  BANK  STATEMENT  160 

States.  A  national  bank  which  issues  notes  for  cir- 
culation (national-bank  notes)  must  contribute  a  fund 
amounting  to  5  per  cent  of  these  notes  in  order  that  the 
Treasury  Department  can  redeem  them  when  pre- 
sented by  the  holders. 

Due  from  the  Treasurer  of  the  United  States.  In  the 
course  of  its  daily  business,  a  bank  receives  govern- 
ment paper  money  which  has  been  mutilated  while  in 
circulation.  Such  bills  are  forwarded  to  the  Treasury, 
which  in  exchange  returns  new  ones. 

Interest  Earned  but  Not  Collected.  When  a  bank 
grants  loans  to  its  customers,  they  pay  the  interest 
usually  at  maturity,  although  it  gradually  accumulates 
or  accrues  during  the  entire  period  for  which  the  loan 
runs.  Thus  interest  returns  on  loans  and  also  on 
investments  are  regarded  as  accrued  assets,  although 
payment  has  not  actually  been  made. 

III.  Liabilities  of  a  Bank. 

The  following  are  the  bank's  liabilities  or  obligations 
which  are  due  to  its  stockholders  and  creditors. 

Capital  Stock.  At  the  organization  of  the  bank,  its 
shares  are  purchased  by  individuals,  who  must  pay 
cash  for  them.  The  bank  thus  becomes  accountable 
to  the  shareholders  for  the  amount  of  the  capital  stock 
and  hence  it  is  carried  as  a  liabihty.  The  original 
capital  stock  may  be  augmented  from  the  surplus  if  the 
earnings  of  the  bank  justify  this  policy.  Capital  stock 
is  a  safeguard  to  depositors,  for  the  sum  which  it 
represents  can  be  applied  to  settle  claims  against  the 
bank  in  case  of  insolvency. 

Surplus.  Surplus  also  may  be  the  result  either  of 
payments  originally  contributed  by  stockholders  or 
profits  gradually  accumulated  by  the  bank.  Surplus 
acts    as    a    means    of    providing    additional    working 


170  BANKING  AND  BUSINESS 

capital  for  expanding  the  business  of  the  bank,  and 
also  operates  as  a  bulwark  for  meeting  possible  losses. 

Undivided  Profits.  These  are  earnings  which  have 
not  been  distributed  to  stockholders  nor  carried  over 
to  surplus,  but  retained  as  a  buffer  in  case  of  emergency. 
Capital  stock,  surplus,  and  undivided  profits  are  items 
grouped  together  under  the  term  ''capital  invest- 
ment." All  three  are  closely  related,  for  undivided 
profits  flow  into  surplus,  which  in  turn  may  be  added 
to  capital  stock.  In  the  event  that  other  assets  are 
insufficient  to  satisfy  the  claims  of  creditors,  un- 
divided profits  are  first  used,  and  if  necessary  the 
surplus  is  next  attached,  while  only  in  an  emergency 
is  the  capital  stock  impaired,  for  such  step  may  bring 
the  bank  to  dissolution.  So  the  greatest  fluctuations 
occur  in  the  item  of  undivided  profits,  and  the  least  in 
capital  stock.  The  capital  investment  does  not  con- 
sist of  actual  cash,  but  is  the  result  of  bookkeeping 
entries,  and  merely  expresses  the  excess  value  of  the 
bank's  resources  over  its  liabilities.  The  same  thought 
is  conveyed  in  the  bookkeeping  formula :  resources  = 
liabilities -|- net  worth  of  the  owners  of  the  business. 
Thus  the  two  sides  of  a  bank  statement  are  always 
made  to  equal  each  other  by  either  increasing  or 
decreasing  the  amount  of  capital  investment. 

Dividends  Unpaid.  These  have  been  declared  by  the 
bank,  but  for  some  reason  have  not  as  yet  been  -wdth- 
drawn  by  the  shareholders,  who  have  a  direct  claim 
on  these  sums. 

Discount  Collected  but  Not  Earned.  When  a  bank 
discounts  a  customer's  note,  the  interest  charge  is 
deducted  in  advance.  The  amount  is  not  really  earned 
by  the  bank  until  the  date  when  the  discounted  paper 
matures.  While  the  bank  thus  has  possession  of  the 
sums  arising  from  these  discounts,  they  are  not  the 
property  of  the  bank  and  so  are  carried  as  liabilities. 


THE   BANK   STATEMENT  171 

This  item  is  the  inverse  of  the  account  "interest  earned 
but  not  collected." 

Amount  Reserved  for  Taxes  Accrued.  A  bank,  the 
same  as  any  other  corporation,  must  pay  several  kinds 
of  taxes.  The  federal  government  le\'ies  the  national 
income,  excess-profits,  and  usual  corporation  taxes 
upon  all  banks.  If  a  bank  issues  circulating  notes, 
these  instruments  are  also  subject  to  a  federal  levy. 
The  state  government  also  taxes  bank  stock,  since  it  is 
a  form  of  personal  property.  All  real  property,  such 
as  bank  building  and  ground,  is  assessed  and  taxed 
by  the  local  government.  Although  the  bank  pays 
these  taxes  at  different  times  throughout  the  year,  the 
total  amount  can  be  estimated  from  past  payments 
and  a  proportionate  sum  is  usually  set  aside  each 
month  to  anticipate  this  expenditure.  This  item, 
as  well  as  the  two  following,  are  called  accrued 
liabilities. 

Amount  Reserved  for  Interest  Accrued.  Another  im- 
portant item  of  expense  is  the  payment  of  interest  due 
to  customers  on  daily  balances  or  on  their  certificates 
of  deposit,  and  to  others  who  have  loaned  money  to 
the  bank. 

Amount  Reserved  for  Expenses  Accrued.  A  large  bank 
usually  compiles  a  budget  covering  salaries,  supplies, 
and  general  expenses  of  operation.  It  is  thus  able  to 
estimate  annual  expenses  and  distribute  this  amount 
in  monthly  or  weekly  installments  throughout  the 
entire  year. 

Circulating  Notes  Outstanding.  National  banks  are 
still  permitted  to  issue  circulating  notes  based  on  the 
security  of  certain  United  States  bonds,  and  this  ac- 
count represents  the  bank's  indebtedness  to  holders  of 
its  notes. 

Net  Amounts  Due  to  Other  Banks,  Bankers,  and  Trust 
Companies.     These  institutions  are  carrying  demand 


J  72  BANKING  AND   BUSINESS 

deposits  "vvith  the  bank  in  order  to  maintain  balances 
against  which  drafts  may  be  drawn. 

Demand  Deposits.  They  are  balances  left  by  indi- 
viduals or  corporations  and  can  be  withdrawn  on  de- 
mand or  on  notice  of  less  than  thirty  days.  They  are 
created  either  through  cash  deposited  by  customers  or 
through  credit  extended  by  the  bank. 

Time  Deposits.  This  item  includes  savings  accounts 
and  certificates  of  deposit  which  cannot  be  withdrawn 
on  demand  without  the  consent  of  the  bank,  but  are 
payable  after  the  bank  has  received  notice  of  thirty 
days. 

United  States  Deposits.  Funds  derived  from  postal 
savings  or  from  internal  and  external  sources  of  federal 
revenue  are  deposited  in  banks  throughout  the  country. 

State,  County,  and  Municipal  Deposits.  Local  gov- 
ernments also  use  the  banks  as  depositories  of  funds. 

Certified  Checks  Outstanding.  When  a  bank  certifies 
a  check  drawn  by  a  customer,  it  charges  the  amount 
to  his  account  and  assumes  the  obligation  for  payment. 
The  instrument  then  becomes  the  direct  liability  of  the 
certifying  bank. 

Cashier^ s  Checks  Outstanding.  These  items  are  drawn 
by  the  cashier  on  the  bank  itself.  Such  instruments 
are  used  to  remit  funds,  to  give  borrowers  the  proceeds 
of  loans,  or  to  pay  the  general  disbursements  of  the 
bank. 

Bonds  Borrowed.  These  are  not  the  property  of  the 
bank,  but  are  borrowed  in  order  to  comply  with  the 
regulations  requiring  these  securities  as  collateral  for 
circulating  notes  or  for  government  deposits. 

Bills  Payable  and  Rediscounts.  In  general,  a  bill 
payable  is  evidence  of  an  unpaid  debt  which  one  owes 
to  another.  A  bank,  the  same  as  a  corporation,  may 
borrow  funds  by  giving  its  note,  which  then  becomes  a 
bill  payable.  On  the  basis  of  this  instrument,  a  member 


THE   BANK   STATEMENT  173 

bank  may  receive  an  advance  from  the  district  Federal 
Reserve  bank.  This  institution  will  also  extend  credit 
indirectly  to  a  member  bank  by  rediscounting  certain 
classes  of  commercial  paper  of  the  latter's  customers. 
Whereas  formerly  individual  banks  in  the  larger  centers 
alone  granted  accommodation  to  other  banks,  since 
1914  the  Federal  Reserve  banks  have  rendered  a  similar 
service. 

Letters  of  Credit  and  Acceptances  Outstanding.  This 
account  is  an  offset  to  the  asset,  ''customers'  liability 
under  letters  of  credit  and  on  account  of  acceptances." 
When  a  bank  issues  a  letter  of  credit,  it  agrees  to  accept 
the  drafts  of  the  seller  of  the  goods.  The  bank  thus 
assumes  a  liability  to  the  amount  specified  in  the  letter 
of  credit.  Drafts  accepted  by  the  bank  are  its  obliga- 
tions and  are  known  as  acceptances. 

IV.  Analysis  of  Transactions. 

In  order  to  indicate  clearly  the  way  various  transac- 
tions give  rise  to  items  in  the  statement,  the  business 
conducted  in  the  first  few  days  of  a  new  bank  will  serve 
as  a  basis  for  analysis.  To  simplify  the  explanation  of 
this  subject,  a  record  will  be  made  only  of  those  accounts 
in  the  statement  which  are  affected  by  each  transaction. 
A  plus  or  minus  sign  will  be  used  to  indicate  an  increase 
or  decrease  in  the  amount  of  each  item.  Lastly,  a 
completed  statement  showing  the  result  of  these 
changes  will  be  presented. 

In  a  small  city,  the  X  National  Bank  is  organized 
under  a  charter  which  authorizes  the  issue  of  one 
thousand  shares  of  capital  stock  with  a  par  value  of 
$100  each.  In  order  to  comply  immediately  with  the 
national  bank  regulations  rcquiringa  bank  to  accumulate 
a  surplus  of  at  least  20  per  cent  before  dividends  can 
be  paid,  the  shares  are  sold  at  a  price  of  SI 20,  thus 


174  BANKING  AND  BUSINESS 

realizing  the  sum  of  $120,000.  As  a  result,  the  initial 
statement  reads  as  follows: 

Assets  Liabilities 

Cash $120,000      Capital  stock $100,000 

Surplus 20,000 

The  directors  then  buy  a  building  for  $20,000  and 
spend  $5,000  for  equipment,  all  of  which  they  pur- 
chase with  cash. 

Assets 

Cash -$25,000 

Banking    house +  20,000 

P\irniture    and    fix- 
tures   +     5,000 

These  two  transactions  affect  the  statement  of  the  bank 
each  in  a  different  way.  In  the  first  case  both  asset 
and  liability  sheets  of  the  ledger  were  increased  by  the 
same  amount.  The  second  transaction  affected  only 
the  asset  accounts,  of  which  one  was  decreased  and  two 
others  increased,  so  that  the  net  total  of  the  assets 
always  remained  the  same. 

In  order  to  become  a  member  of  the  Federal  Reserve 
system  the  X  National  Bank  must  purchase  stock  in 
the  district  Reserve  bank  to  an  amount  equaling  6  per 
cent  of  the  former's  capital  and  surplus.  Up  to  the 
present  member  banks  have  been  required  to  pay 
actually  3  per  cent  of  this  sum.  The  X  Bank  there- 
fore buys  Federal  Reserve  bank  stock  to  the  amount 
of  $3,600  and  pays  for  it  in  cash. 

Assets 

Cash -$3,600 

Federal    Reserve 

stock +  3,600 

The  bank  begins  operations  'udth  a  group  of  new 
depositors  opening  checking  accounts  and  leaving 
$10,000  in  cash.  Thus  the  bank's  assets  in  cash  will  be 
increased  and  the  hability  side  of  the  ledger  will  show 


THE   BANK   STATEMENT  175 

a  new  item  in  the  form  of  demand  deposits.  In  this 
case  the  total  assets  and  habiUties  are  correspondingly 
increased,  while  the  two  previous  sets  of  transactions 
left  them  unchanged. 

Assets  Liabilities 

Cash +.?10,000      Demand  deposits. . .     +$10,000 

One  customer,  with  $1,000  for  which  he  has  no  im- 
mediate use,  leaves  it  with  the  bank,  on  the  under- 
standing that  the  bank  may  require  thirty  days'  notice 
of  withdrawal,  and  so  a  time  instead  of  a  demand 
deposit  is  created. 

Assets                                                         Liabilities 
Cash +$1,000      Time  t' -posits +$1,000 

A  number  of  other  customers  start  new  accounts  by 
depositing  $10,000  in  checks  drawn  against  their 
balances  with  other  banks  in  the  community.  Assum- 
ing that  these  institutions  are  members  of  the  local 
clearing  house,  the  X  Bank  will  secure  payment  of  the 
checks  on  the  following  day.  Meantime  the  amount  of 
these  instruments  will  be  added  to  the  accounts  of 
the  depositors. 

Assets  LiAniLiTiES 

Exchanges    for    the 
clearing  house +$10,000      Demand  deposits. . .     +$10,000 

Several  customers  seek  demand  loans  from  the  bank 
and  offer  the  stock  of  certain  local  corporations  as 
security.  This  stock  is  held  by  the  bank  merely  as 
collateral,  and  does  not  appear  in  the  statement,  as 
the  asset  which  the  bank  holds  is  not  the  stock  itself, 
but  the  note  reflecting  the  sum  due  it  from  the  bor- 
rowers. The  bank  agrees  to  lend  $20,000  to  its 
customers,  who  do  not  desire  cash,  but  credit  to 
their  deposit  accounts. 

Assets  LiADiLmES 

Loans +$20,000      Demand  deposits. . .     +$20,000 


176  BANKING  AND   BUSINESS 

Thus  it  is  seen  that  a  bank's  deposits  may  be  increased 
in  three  ways:  (1)  cash  left  by  customers,  (2)  checks 
and  cash  items  drawn  on  other  institutions,  (3)  loans 
granted  by  the  bank  itself. 

The  discounting  of  a  note  may  have  a  similar  effect 
upon  a  customer's  balance.  For  example,  a  depositor 
who  is  a  local  manufacturer  requests  the  bank  to  dis- 
count his  own  sixty-day  note  of  $10,000  in  order  that 
he  may  buy  raw  material.  The  note  is  taken  by  the 
bank  at  the  rate  of  6  per  cent.  With  the  discount, 
the  charge  to  the  borrower  is  deducted  in  advance,  and 
not,  as  in  the  case  of  a  loan,  at  maturity.  In  this 
transaction  the  discount  amounts  to  $100,  and  so  the 
borrower  receives  not  the  full  face  amount  of  the  note, 
but  only  the  proceeds,  $9,900.  This  sum  is  added  to 
the  amount  of  deposits,  while  the  $100  is  carried  as 
discount  collected  but  not  earned.  As  the  customer  is 
indebted  to  the  bank  for  the  full  amount  of  the  note, 
it  is  so  entered  under  the  item  of  discounts. 

Assets  Liabilities 

Discounts +$10,000      Demand  deposits. . .      +$9,900 

Discount    collected 
but  not  earned. . .      +      100 

As  the  institution  under  consideration  is  a  national 
bank,  it  is  permitted  to  issue  notes  for  circulation, 
provided  it  deposits  with  the  Treasury  of  the  United 
States  at  Washington  an  equal  amount  of  government 
bonds  and  in  addition  contributes  5  per  cent  to  the 
Redemption  Fund  maintained  with  the  Treasurer. 
The  directors  first  authorize  the  purchase  of  $20,000 
worth  of  United  States  2-per-cent  bonds  bearing  the 
circulation  privilege  and,  let  us  assume,  selling  at  a  par 
value  of  $100,  for  which  cash  is  paid. 

ASBETB 

Cash -$20,000 

United  States  bonds    +  20,000 


THE   BANK  STATEMENT  177 

At  the  same  time  the  bank  sends  to  the  Treasurer 
$400  as  the  required  deposit  of  5  per  cent  in  the  Re- 
demption Fund. 

Assets 

Cash -51,000 

Redemption  Fund .  .         +  1,000 

Having  observed  all  regulations,  the  bank  now 
issues  its  notes  to  the  amount  of  $20,000.  These 
instruments  are  placed  in  circulation  by  giving  them 
to  customers  who  have  received  credit  from  the  bank. 
It  can  thus  grant  loans  by  increasing  the  deposit  ac- 
counts of  its  customers  or  by  giving  them  its  circulating 
notes. 

Assets  Liabilities 

Circulating    notes 
Loans +820,000  outstanding +§20,000 

In  addition  to  buying  United  States  bonds,  the  bank 
invests  its  funds  in  a  form  of  short-term  government 
obligations  issued  since  1917,  known  as  certificates  of 
indebtedness.  The  bank  buys  $5,000  worth  of  these 
securities  which,  let  us  assume,  have  just  been  issued, 
and  so  no  accrued  interest  need  be  paid. 

Assets 

Cash -S5,000 

Certificates    of    in- 
debtedness        +  5,000 

With  these  securities  as  collateral  the  bank  is  able 
to  obtain  a  fifteen-day  loan  of  S3, 000  from  the  Federal 
Reserve  bank.  This  step  is  taken  in  order  to  estabhsh 
the  legal  percentage  of  reserve  which  it  is  reciuired  to 
maintain  against  the  deposits  of  its  customers.  This 
reserve  is  carried  in  the  form  of  an  account  with  the 
Federal  Reserve  bank.  Thus  the  X  Bank  gives  its  note, 
which  becomes  a  bill  payable,  and  in  return  it  receives 
credit  to  its  reserve  account  with  the  Federal  Reserve 


178  BANKING  AND  BUSINESS 

bank.  In  analyzing  this  transaction,  it  must  be  remem- 
bered that  as  a  matter  of  practical  operation  the  X 
Bank  would  not  receive  a  loan  until  it  is  a  going  insti- 
tution and  until  an  increase  in  its  demand  deposits 
necessitates  this  step. 

Assets  Liabilities 

Lawful  reserve +$3,000      BiUs  payable +$3,000 

The  same  general  relationship  exists  between  the 
Federal  Reserve  bank  and  the  X  National  Bank  as  be- 
tween the  latter  institution  and  its  own  customers. 
As  indicated  above,  they  received  credit  from  the  X 
Bank  through  the  granting  of  loans  on  their  obligations 
secured  by  collateral,  or  through  the  discounting  of 
notes  received  from  their  own  customers.  In  the  above 
transaction  the  Federal  Reserve  bank  granted  an 
advance  to  the  X  Bank  on  its  note  accompanied 
by  certificates  of  indebtedness  as  collateral.  In  like 
manner,  the  X  Bank  may  bring  certain  classes  of 
notes  which  it  has  discounted  to  the  Federal  Reserve 
bank  for  rediscount.  In  a  previous  transaction  the 
bank  discounted  a  sixty-day  note  of  $10,000  for  a 
manufacturer.  This  obhgation,  accompanied  by  a  satis- 
factory financial  statement  of  the  manufacturer,  meets 
the  required  tests  of  eligibility,  and  so  the  Federal  Re- 
serve bank  rediscounts  it  at  the  rate  of  5  per  cent  for  sixty 
days.  It  may  extend  this  credit  by  adding  the  amount 
to  the  deposit  of  the  X  Bank.  This  institution  feels  that 
its  balance  is  sufficient  and  therefore  prefers  to  take  out 
the  proceeds  of  the  rediscount  in  the  form  of  Federal 
Reserve  notes,  which  it  can  in  time  pay  out  as  depositors 
make  withdrawals. 

Assets  LiABiLmES 

Cash +$9,916.66      Rediscounts +$10,000 

Interest  paid +83 .  34 

It  is  quite  necessary  for  a  country  bank  to  establish 
correspondent  relations  with  an  institution  located  in  a 


THE  BANK  STATEMENT  179 

large  money  center,  therefore  the  X  Bank  opens  an 
account  with  a  bank  in  New  York  City  by  giving  it  a 
cash  deposit  of  $20,000. 

Assets 

Cash -820,000 

Due    from    other 
banks +  20,000 

Various  withdrawals  are  made  by  customers  against 
their  accounts.  A  check  of  SI, 000  is  drawn  by  one  de- 
positor in  favor  of  another  customer  of  the  bank.  This 
transaction  involves  merely  the  debiting  of  one  balance 
and  the  crediting  of  another  on  the  individual  ledgers, 
but  no  change  is  made  in  the  account  of  deposits  on  the 
general  ledger  of  the  bank,  as  its  total  deposits  remain 
the  same.  A  number  of  customers  draw  checks  amount- 
ing in  all  to  .$15,000  in  favor  of  depositors  in  banks  at 
other  points.  These  institutions  send  the  checks  to  the  X 
Bank,  which  creates  a  new  liability  account  by  crediting 
these  other  banks  and  at  the  same  time  deducting  the 
amount  from  its  depositor's  accounts. 

Liabilities 

Due  to  other  banks.    +515,000 
Demand  deposits. . .     —  15,000 

A  customer  draws  for  an  amount  which  exceeds  his 
balance  by  $150.  This  overdraft  is  practically  a  forced 
loan,  and  so  the  same  entries  are  made  as  if  the  bank 
had  extended  credit  to  the  customer.  His  account  is 
increased  by  $150,  and  as  an  offset  the  same  amount  is 
carried  as  an  overdraft. 

Assets  Liabilities 

Overdrafts +$150      Demand  deposits .. .         +$150 

A  customer  requests  the  bank  to  certify  his  check  lor 
$500.  His  account  is  examined  by  the  bookkeeper  and 
shows  a  balance  sufficient  to  cover  the  amount.  In 
certifying  a  check  the  bank  transfers  the  hability  for 


180  BANKING  AND  BUSINESS 

payment  from  the  drawer  to  itself.  Therefore  the 
amount  of  the  check  is  deducted  from  the  depositor's 
balance  and  set  aside  in  a  special  account  for  certified 
checks. 

Liabilities 
Demand  deposits. . .         —$500 
Certified  checks ... .  +500 

The  bank  installs  a  vault  at  a  cost  of  $2,000  and 
pays  for  it  with  a  cashier's  check. 

Assets  Liabilities 

Furniture    and    fix- 
tures        +$2,000      Cashier's  checks. . . .      +$2,000 

At  the  request  of  a  customer  the  bank  issues  a  letter 
of  credit  amounting  to  $3,000.  Although  this  Hability  is 
fully  undertaken  by  the  bank,  at  the  same  time  it  is 
covered  by  an  equal  obligation  of  the  customer. 

Assets  Liabilities 

Customers'  liability 
under    letters    of                        Letters  of  credit  out- 
credit +$3,000  standing +$3,000 

Assuming  that  these  transactions  have  occurred  con- 
secutively in  the  course  of  several  days'  business,  the 
completed  statement  of  the  bank  will  read  as  per  table 
on  page  181. 

V.  Classification  of  Assets  and  Liabilities. 

The  bank's  assets  and  liabilities  first  were  viewed  as 
independent  items  and  in  the  previous  section  they  were 
considered  in  relation  to  one  another.  From  this  sur- 
vey, it  is  evident  that  the  accounts  fall  logically  into 
several  distinct  classes  which  will  be  briefly  analyzed. 
In  general,  assets  may  be  divided  on  the  basis  of 
Uquidity  as  follows:   (1)  cash  in  the  bank,  (2)  amounts 


THE   BANK  STATEMENT 


181 


due  from  banks,  (3)  loans  and  investments,  (4)  real 
property.  Naturally  cash  is  the  most  liquid  resource, 
and  a  certain  amount  must  be  kept  in  the  till  as  a  means 
of  immediate  payment,  and  in  the  bank  vault  as  a 

Statement  of  the  X  Nationax,  Bank 
Assets  Liabilities 


Capital §100,000 

Surplus 20,000 

Interest  and  discount 
collected     but     not 

earned 100 

Circulation    outstand- 
ing    20,000 

Demand  deposits.  . . .  34,550 

Time  deposits 1,000 

Certified  checks 500 

Cashier's  checks 2,000 

Bills  payable  with  Fed- 
eral Reserve  bank. . .  3,000 

Due  to  banks 15,000 

Bills  rediscounted 10,000 

Letters  of  credit   out- 
standing   .^^  3,000 

$  200,150.00 


Loans  and  discounts  §50,000.00 

Overdrafts 150.00 

Customers'  liability 
under  letters  of 
credit  and  accept- 
ances       3,000.00 

United  States  bonds 
and  certificates  of 
indebtedness 25,000-00 

Stock  of  Federal  Re- 
serve bank 3,600.00 

Banking  house 20,000-00 

Furniture  and  fix- 
tures       7,000.00 

Lawful  reserve 3,000.00 

Cash  in  vault 66,916.66 

Due  from  other 
banks 20,000.00 

Exchanges  for  clear- 
ing house 10,000.00 

Redemption  Fund..         400,00 

Interest  paid .^ 83.34 

$  209,150.00 

dormant  reserve  for  emergency.  But  this  money  is  idle, 
and  an  oversupply  t^nds  to  reduce  earnings. 

The  second  group,  due  from  banks,  includes:  (1)  law- 
ful reserves  from  Federal  Reserve  bank,  (2)  due  from 
other  banks,  (3)  exchanges  for  the  clearing  house, 
(4)  checks  on  other  banks  in  the  same  city,  (5)  it^ms 
with  the  Federal  Reserve  bank  in  process  of  collection. 

An  account  with  the  Federal  Reserve  bank  can  he 
drawn  upon  immediately  and  is  thus  the  equi\alcnt  of 
cash.  Similar  availal)ility  is  found  in  balances  due  from 
other  banks.     Exchanges  on  the  clearing  house  and 


182  BANKING  AND  BUSINESS 

checks  on  other  banks  in  the  same  city  are  practically 
demand  claims.  Items  in  process  of  collection,  of  course, 
are  payable  only  after  a  period  of  time  which  may  take 
several  days. 

The  third  group  of  loans  and  investments  will  vary 
in  Uquidity,  depending  upon  the  maturity  of  the  loans 
and  the  marketability  of  the  investments.  The  bank's 
building,  equipment,  and  ground  are  distinctly  fixed 
assets. 

The  liability  accounts  may  best  be  grouped  according 
to  the  parties  who  have  claims  against  the  bank- 
namely,  (1)  stockholders,  (2)  depositors,  (3)  other 
banks,  (4)  general  public. 

The  stockholders  are  really  the  owners  of  the  capital, 
surplus,  undivided  profits,  and  unpaid  dividends.  The 
depositors  may  be  individuals,  banks,  or  governments, 
and  they  have  claim  to  balances  which  may  be  payable 
on  demand  or  on  time.  The  bank  is  also  debtor  to  out- 
side institutions  which  have  loaned  on  bills  payable  or 
rediscounts,  and  to  persons  who  are  holding  its  obliga- 
tions in  the  form  of  circulating  notes,  cashiers'  checks, 
certified  checks,  acceptances,  and  letters  of  credit. 

VI.  Analysis  of  a  Bank  Statement. 

The  statement  of  a  bank  reveals  its  condition  on  a 
certain  date,  and  when  several  past  statements  are 
compared  its  record  over  a  given  period  of  time  may  be 
ascertained.  The  various  items  will  gradually  come  to 
bear  certain  more  or  less  definite  relations  to  one  an- 
other. Their  relations  will  vary  in  considerable  manner 
among  banks,  both  according  to  the  section  in  which 
they  are  located  and  the  type  of  business  which  they 
handle,  and  for  banks  in  general  they  \\all  also  vary  in 
response  to  changes  which  take  place  in  general  business 
conditions.     Banks,  especially  in  the  larger  centers, 


THE  BANK  STATEMENT  183 

which  regularly  lend  to  other  institutions,  consider 
carefully  the  statement  of  condition  which  a  prospective 
bank  borrower  furnishes  before  a  loan  is  granted.  They 
regularly  analj^ze  the  statement  and  study  the  rela- 
tions which  certain  of  the  items  bear  to  one  another. 
While  these  relations,  as  just  indicated,  are  by  no 
means  absolute,  certain  general  limits  have  become 
established. 

In  analyzing  the  bank's  statement  several  tests 
are  applied.  On  the  one  hand,  the  profitableness  of 
the  account  of  the  institution  is  considered.  This  is 
supplemented  by  an  analysis  of  the  character  of  its 
assets,  especially  for  the  purpose  of  seeing  if  the  bank 
is  in  a  sufficiently  liquid  condition. 

The  profitableness  of  the  prospective  borrower  is 
shown  in  several  ways.  The  primary  test  is  to  consider 
the  ratio  which  deposits  bear  to  the  capital  invest- 
ment, including  in  the  latter  term  capital,  surplus,  and 
undivided  profits.  It  is  generally  accepted  that  a  bank 
which  shows  a  ratio  of  less  than  five  to  one  between 
deposits  and  capital  investment  is  conducting  too  small 
a  volume  of  business  for  the  capital  investment.  On 
the  other  hand,  a  bank  which  shows  a  ratio  of  more  than 
ten  to  one  is  conducting  too  large  a  business  and  should 
increase  its  capital,  as  the  high  ratio  does  not  provide 
sufficient  margin  of  safety  in  the  event  of  the  bank's 
failure.  This  test  may  be  supplemented  by  observing  the 
ratio  which  loans  bear  to  deposits,  to  discover  any 
tendency  toward  overlending.  This  test  is  less  satisfac- 
tory because  the  ratio  varies  greatly  according  to  mone- 
tary conditions,  decreasing  as  stringency  is  noted.  The 
third  test  lies  in  comparing  the  growth  of  surplus  and 
undivided  profits  over  a  series  of  years  as  well  as  the 
dividend  record  of  the  institution. 

In  studying  the  character  of  the  assets,  attention  is 
directed  to  the  proportion  of  fixed  assets,  such  as  bank 


184  BANKING  AND   BUSINESS 

building,  real  estate,  furniture,  and  fixtures.  The 
amount  which  a  bank  invests  in  its  premises  should  be 
proportioned  to  the  volume  of  its  business  and  to  its 
capital,  while  similarly  it  should  not  hold  real  estate 
other  than  that  which  is  necessary  to  conduct  its  affairs. 
Other  assets  which  may  possibly  become  slow  are  also 
considered — for  example,  unlisted  stocks  and  bonds. 
Of  primary  importance  with  respect  to  liquidity  is  of 
course  the  reserve  position  of  the  institution,  and  at- 
tention will  always  be  given  to  the  reserve  ratio  which 
the  bank's  statement  shows. 

Supplementing  these  two  types  of  information,  a 
lending  bank  considers  the  past  record  of  the  applicant 
with  respect  to  borrowings.  The  lending  institution  is 
often  furnished  with  a  statement  of  the  total  borrow- 
ings of  the  applicant  from  other  sources  as  well  as  from 
itself.  This  serves  to  indicate  how  the  applicant  has 
been  conducting  its  affairs  and  also  to  show  whether 
it  has  borrowed  only  for  seasonal  and  extraordinary 
needs  and  has  followed  the  usual  practice  of  "cleaning 
up"  its  indebtedness  to  the  banks  each  year.  Another 
source  of  information  will  be  the  manner  in  which  the 
borrowing  bank  has  in  the  past  conducted  its  accounts 
with  the  lending  institution,  especially  whether  it  has 
made  a  practice  of  overdrawing  against  uncollect-ed 
items  or  whether  it  has  been  conservatively  and  care- 
fully managed. 


CHAPTER  XII 

RATES  OF  INTEREST  AND  DISCOUNT 

I.  Adjustment  of  Cost  in  General  Business. 

Every  business  institution  has  to  consider  the  rate 
of  charge  which  it  will  be  able  to  make  for  its  service 
or  product,  and  the  establishment  of  such  rates  is  often 
one  of  the  most  serious  problems  in  business  manage- 
ment. The  retailer  is  constantly  faced  with  the  neces- 
sity of  keeping  his  charges  at  such  a  level  as  will  net 
him  a  profit  above  cost,  while  at  the  same  time  he 
avoids  loss  through  excess  of  expense  over  income. 
The  apportionment  of  different  items  of  operating  cost 
to  the  different  charges  for  service  or  goods  is  a  sp)ecial 
phase  of  the  general  problem  herein  referred  to  and  is 
itself  highly  technical.  It  always  offers  serious  dif- 
ficulties as  an  element  in  practical  business  policy. 

In  banking  the  same  problems  have  to  be  met,  and 
while  they  present  some  peculiar  phases  or  elements  of 
difficulty,  they  are  in  the  main  identical  with  the 
questions  of  the  same  description  which  are  encoun- 
tered in  ordinary  business.  Still  it  is  true  that  business 
enterprises  are  not  all  interested  in  this  problem  in 
precisely  the  same  way.  Contrast,  for  example,  the 
case  of  a  municipal  street  railway  which  has  entered 
into  a  contract  to  carry  passengers  at  a  five-cent  fare. 
The  problem  of  profit  for  it  is  largely  a  problem  of  keep- 
ing dowTi  expenses,  since  the  rat^e  of  its  charge  is  prac- 
tically stable.    True,  it  may  be  possible,  by  proper 


186  BANKING  AND   BUSINESS 

adaptation  of  service,  to  adjust  its  charges  in  an 
indirect  way,  as  when  special  cars  are  run  for  long- 
distance traffic  on  an  express  basis,  thus  avoiding  the 
cost  of  intermediate  stops,  while  other  cars  are  run  for 
local  traffic,  but  in  the  main  the  problem  is  very  simple. 
At  the  other  extreme  of  the  problem  of  price"  adjust- 
ment is  the  case  of  a  manufacturer  who  has  to  fix  his 
charges  on,  say,  one  hundred  different  items  or  kinds 
of  product,  adapting  his  accounting  so  as  to  apportion 
overhead  costs  as  well  as  individual  costs  to  the  several 
items.  Intermediate  is  perhaps  the  problem  of  tho 
railway  which  carries  both  passengers  and  freight  and 
which  perhaps  divides  its  passenger  traffic  into  two 
or  three  classes,  while  its  freight  is  classified  on  a  verj- 
complex  schedule  designed  to  adapt  the  rates  to  the 
different  freight  movements. 

II.  Influence    of    Competition    in    Determining 
Bank  Charges. 

The  bank  corresponds  probably  more  nearly  in  its 
price-fixing  problem  to  the  public-service  corporation 
than  to  any  single  type  of  industrial  business.  While 
within  certain  limits  the  bank  can  establish  its  own 
scale  of  charges,  it  cannot  fix  these  in  any  one  instance 
very  differently  from  the  rates  which  are  estabhshed  in 
the  open  market  unless  it  wants  to  cut  itself  off  from 
business.  Banking  is  a  highly  competitive  enterprise 
and  is  not  ordinarily  monopolistic  in  any  sense  of  the 
term,  so  that  the  bank  is  always  obliged  to  face  the 
question  of  competition  and  of  market  rates.  When  the 
banker  goes  into  business  he  has  to  recognize,  there- 
fore, that  his  rates  must  under  ordinary  conditions 
conform  to  those  which  prevail  in  the  community  at 
the  time,  and  that  he  will  not  ordinarily  be  able  to 
raise  them  very  much  merely  because  of  his  own  costs 


INTEREST  AND  DISCOUNT  RATES    iS7 

or  expenses.  Good  management  in  banking  (assuming 
that  only  sound  paper  is  bought  and  that  no  losses  are  in- 
curred) is  thus  a  problem  which  in\'olves  two  elements — 
that  of  costs  and  that  of  investment  of  funds  in  such 
a  way  as  to  get  the  best  return  from  them.  The  former 
question,  that  of  cost  of  operation,  may  be  reserved 
for  treatment  elsewhere  (see  Chapter  XIII).  At  this 
point  it  is  desired  to  consider  merely  the  question  of 
charges  for  services,  and,  as  has  already  been  indicated, 
this  question  is  in  large  measure  a  question  of  com- 
petitive conditions,  since  the  banker  must  accept  the 
situation  prevailing  in  the  community. 

III.  Rates  on  Loans  and  Discounts  to  Customers. 

Several  sources  of  income  may  be  recognized  at  any 
bank.    They  may  be  classified  roughly  as  follows : 

1.  Income  from  loans  and  discounts.  (^ 

2.  Profit  from  exchange  or  remittances.*^ 

3.  Charges  for  collections.       l^ 

4.  Miscellaneous  service  charges.  4^ 

Of  these  sources  of  income  the  one  which  is  chiefly 
interesting  to  the  banker  is  the  first  named,  the  receipts 
from  loans  and  discounts.  The  income  from  these 
sources  is  ordinarily  referred  to  as  "interest"  or  "dis- 
count," the  term  "interest"  referring  to  the  amount 
paid  by  the  makers  of  straight  notes,  the  t-erm  "dis- 
count;" to  the  charge  made  for  anticipating  the  matur- 
ity of  the  obligation  which  has  been  made  for  a  named 
amount  due  on  a  specified  date.  It  is  clear,  however, 
that  the  banker  has  always  open  to  him  the  choice 
whether  to  confine  his  funds  to  lending  or  discounting 
the  paper  of  customers  wlio  come  direct  to  the  bank,  or 
of  using  it  in  what  is  called  the  open  market — that  is 


188  BANKING  AND   BUSINESS 

to  say,  of  buying  or  discounting  paper  left  with  him  or 
made,  by  persons  who  are  not  his  customers.  The  ap- 
portionment of  funds  between  these  two  fields  is  often^' 
times  difficult,  but,  for  reasons  presently  to  be  stated, 
every  banker  has  to  consider  it  with  some  care.  Turn- 
ing attention  first  of  all  to  the  rate  to  be  charged  upon- 
loans  and  discounts  made  in  business  carried  on  direct 
with  the  customers  of  the  bank,  we  may  recognize  that 
there  is  in  every  community  what  may  be  called  a 
going  rate  of  interest.  This  is  the  outcome  of  the  supply 
of  and  demand  for  capital  and  corresponds  to  the  com- 
munity's judgment  of  what  capital  or  "money"  is 
worth  at  any  given  time.  This  rate  may  be  high  or  low, 
according  to  prevailing  business  conditions.  Thus,  for 
instance,  in  some  Oriental  countries  at  the  present 
time,  the  borrower  does  not  feel  that  he  is  being  badly 
treated  if  he  is  called  upon  to  pay  2  per  cent  per  month, 
or  24  per  cent  per  amaum,  for  a  loan  secured  by  real- 
estate  mortgage.  In  some  parts  of  the  United  States 
to-day  the  rate  of  10  to  12  per  cent  per  annum  on  such 
security  is  perhaps  not  too  much,  while  elsewhere  5 
or  6  per  cent  is  normal.  The  variations  in  such  charges, 
as  has  been  said,  depends  upon  the  adjustment  of 
supply  of  and  demand  for  capital;  but  they  are  also 
influenced  by  the  question  of  risk,  being  high  w^here 
the  experience  shows  that  losses  are  large,  and  low 
where  losses  are  small.  So  also  in  the  case  of  loans  on 
commodities  or  securities,  rates  vary  much  between 
different  communities  in  accordance  with  the  relative 
supply  of  and  demand  for  capital  in  those  different 
places,  while  in  the  several  places  themselves  there  is 
always  a  variation  between  types  of  loans  which  involve 
high  risk  and  those  which  involve  relatively  small  risk. 
Inasmuch  as  it  is  difficult  to  foresee  the  future,  a  fact 
which  means  that  there  is  always  a  larger  risk  element 
in  long-term  obligations  than  in  short-term  obUgations, 


INTEREST  AND  DISCOUNT  RATES    189 

it  is  customary  to  regard  long-term  obligations  as  prop- 
erly burdened  with  a  higher  rate  than  short-term. 
Accordingly,  it  may  be  said  that  the  banker  is  con- 
fronted with  a  general  level  of  interest  rates  which 
cannot  be  altered  very  much  by  him,  but  which  depends 
upon  comparison  of  demand  for  and  supply  of  capital. 
On  this  level  he  finds  a  variety  of  uses  in  which  his 
funds  may  be  applied,  and  as  between  those  he  natu- 
rally asks  a  higher  figure  for  advances  which  are  long- 
term  or  risky  or  uncertain,  while  he  is  able  to  reduce  his 
rate  on  those  loans  which  are  short-term,  secured,  and 
liquid.  The  variation  in  rates  at  any  given  time  is  in 
large  measure  determined  by  these  considerations. 

IV.  Loans  and  Discounts  in  the  Open  Market. 

But  since  at  any  given  time  there  are  different  con- 
ditions in  different  communities,  the  banker  has  always 
open  to  him  the  option  of  shifting  his  funds  from  one 
community  to  another.  He  may  transfer  his  funds  to 
New  York,  let  us  say,  and  there  lend  them  in  the  call 
market  at  a  time  when  there  is  a  great  scarcity  of  funds 
in  that  market,  thereby  taking  for  himself  a  larger 
profit  than  he  could  get  at  home.  Or,  he  may  think 
it  well  to  buy  a  certain  amount  of  paper  made  by  out- 
siders, thus  keeping  a  part  of  his  funds  regularly  in  the 
general  commercial-paper  market.  He  may  do  this  in 
the  belief  that  such  paper,  although  it  actually  yields 
less  than  the  paper  of  his  own  customers,  is  desirable 
for  him  because  it  is  rediscountable,  or  because  it  is 
more  certain  of  payment  at  maturity,  since  no  renewal  is 
expected.  There  is  always  open,  therefore,  to  the  banker, 
the  distribution  of  his  funds  between  varying  uses 
which  yield  different  rates  of  interest,  and  his  distribu- 
tion of  funds  will  be  determined  very  largely  by  his 
own  judgment  as  to  the  needs  of  his  community,  cou- 


190  BANKING  AND   BUSINESS 

pled  with  a  comparison  of  the  earnings  that  can  be 
made  at  home  and  those  which  can  be  made  elsewhere. 
There  is  thus  always  to  be  recognized  a  long-term  and 
a  short-term  rate  in  every  community,  while  we  may 
also  recognize  a  customer's  rate  and  an  open-market 
rate.  As  between  the  latter  there  is  no  necessary  rela- 
tionship. One  may  be  higher  than  the  other,  or  lower, 
according  to  circumstances,  although  the  competition 
and  quahty  of  the  paper  in  the  open  market  are  such 
that  the  rate  on  paper  of  that  kind  is  normally  below 
the  rate  charged  direct  to  the  customer  except  in  the 
case  of  the  very  primest  names. 

V.  Legal  Interest  Rate. 

At  this  point  it  may  be  noted  that  many  states  have 
what  are  called  usury  laws  which  specify  that  not 
more  than  a  given  rate  of  interest  is  to  be  charged  for 
any  loan  or  discount.  Such  laws  are  ahvays  difficult 
of  enforcement,  but  they  are  pecuharl}'-  difficult  of 
application  in  the  case  of  the  bank  loan.  If,  for 
example,  a  banker  lends  $10,000  at  6  per  cent,  when  the 
legal  rate  is  6  per  cent,  he  presumably  gets  a  gross 
income  of  S600.  If,  however,  he  lends  $10,000  at  6 
per  cent  and  requires  his  customer  to  keep  an  untouched 
balance  with  him  of  $2,000,  he  is  really  making  a  net 
loan  of  $8,000.  The  customer  gets  the  use  of  $8,000, 
and  since  he  pays  6  per  cent  on  $10,000,  he  is  really 
giving  the  bank  $600  for  the  use  of  $8,000,  or  about 
7}/2  per  cent.  This  way  of  adjusting  rates  of  interest 
can  hardly  be  reached  by  usury  laws,  while  in  various 
cases,  where  market  rates  are  out  of  harmony  with 
the  legal  rate,  many  bankers  bring  about  an  adjust- 
ment by  other  methods.  Nevertheless,  the  legal  rate 
is  always  a  factor  of  some  influence  in  the  establish- 
ment of  rates  on  borrowed  money,  and  it  may  be 


INTEREST  AND  DISCOUNT  RATES    191 

broadly  stated  that  the  general  effect  of  it  is  unsatis- 
factory and  increases  the  amou.it  the  actual  borrower 
is  obUged  to  pay  for  what  he  gets.  This  statement, 
of  course,  would  hold  true  only  when  the  market  rate 
was  above  the  legal  rate,  since,  when  the  rates  is  natu- 
rally below  the  legal  rate,  the  latter  has  little  or  no 
effect  one  way  or  the  other. 

VI.  Call-money  Rate. 

In  the  large  cities  where  securities  speculation  has 
taken  deep  root,  it  is  usually  possible  for  the  bank 
to  employ  some  of  its  funds  in  loans  upon  collateral 
security — that  is  to  say,  to  allow  borrowers  to  use  its 
funds  in  carrying  on  speculati\'e  operations.  Custom 
has  made  these  loans  generally  subject  to  call — that 
is  to  say,  has  made  them  demand  rates,  with  constant 
revision  of  the  rate,  thus  establishing  what  is  or- 
dinarily termed  the  call  market.  This  use  of  funds  is 
quite  outside  the  commercial-paper  field,  and,  as  in  the 
case  of  other  branches  of  business,  the  call  rate  depends 
upon  the  relative  amount  as  compared  with  the  demand 
for  loans  in  that  field.  If  at  anj^  given  time  the 
amount  of  funds  offering  in  the  call  market  is  moderate 
as  compared  with  demand,  the  rate  will  be  high,  and 
vice  versa.  High  call  rates  are  believed  to  draw  into 
the  market  funds  which  would  otherwise  have  been 
used  in  the  purchase  of  commercial  paper,  and  to  some 
extent  this  is  probably  the  case,  but  the  call  rate  is 
in  many  respects  noncompetitive,  and  there  is  ground 
for  a  question  regarding  the  extent  to  which  its  in- 
fluence is  directly  felt  in  diverting  funds  from  other 
uses.  Then,  too,  it  should  be  remembered  that  the 
total  amount  of  funds  normally  applied  on  call  is  much 
more  limited  than  is  usually  supposed.  It  may  be 
estimated  that  for  the  country  as  a  whole  the  amount 


192  BANKING  AND   BUSINESS 

of  time  and  call  loans  is  perhaps  $1,000,000,000,  in 
times  of  good  average  business,  while  the  commercial- 
paper  market  perhaps  requires  about  the  same  amount. 
Taking  the  loans  and  discounts  of  the  banks  as  being, 
in  round  numbers,  $36,000,000,000,  it  would  appear 
that  the  call  market  ordinarily  represents  about  one- 
thirty-sixth  of  the  total  loans  of  the  banks,  and  the 
commercial-paper  market  (open  market)  another  thirty- 
sixth.  These  fractions,  while  they  seem  small,  are 
found  to  act  at  all  times  as  an  equalizer  of  rates.  It  is 
an  important  economic  service  of  the  call  market  that  it 
tends  to '  *  even  up ' '  rates  between  other  branches  of  busi- 
ness and  as  between  different  sections  of  the  country. 
In  most  large  cities,  and  particularly  in  New  York, 
funds  are  loaned  to  a  considerable  extent  by  money 
brokers,  and  there  is  a  "money  post"  on  the  Stock 
Exchange  at  which  call  rates  are  fixed  day  by  day. 
Bankers  make  rates  direct  to  their  own  customers,  and 
to  a  considerable  extent  arrangements  are  consum- 
mated between  out-of-town  and  in-town  bankers 
whereby  the  latter  lend  funds  transmitted  to  them  by 
the  former  on  a  basis  of  participation — that  is  to  say, 
the  total  amount  of  funds  in  hand  is  loaned  by  the 
city  bank,  but  with  the  understanding  that  a  certain 
proportion  is  for  the  account  of  the  out-of-town  corre- 
spondent. Competition  as  between  supply  and  de- 
mand fixes  the  rate  on  the  Stock  Exchange  each  day, 
but  it  often  happens  that  the  outside  market  furnished 
by  the  direct  loans  made  by  money  brokers  to  their 
customers  or  by  banks  to  their  customers  is  below  or 
above  the  official  rate  on  the  Stock  Exchange.  Wlien 
these  discrepancies  occur  it  does  not  take  long  to 
reconcile  them,  since  competition  speedily  sets  in  and 
the  official  quotations  of  the  next  day  or  two  are 
usually  brought  into  harmony  ^vith  those  of  the  out- 
side market,  or  vice  versa. 


INTEREST  AND  DISCOUNT  RATES    193 

VII.  Acceptance  Rates. 

The  acceptance  market  is  a  special  branch  of  the 
general  discount  market  organization,  and  the  rates 
that  are  charged  by  banks  for  accepting  paper  are 
fixed  aft^r  exactly  the  same  principles  that  apply  in 
the  case  of  other  rates.  In  the  case  of  the  acceptance 
rate  there  is  a  rather  more  complex  situation  than  that 
which  exists  in  the  case  of  direct  loans  and  discount 
rates.  A  business  man  has  asked  a  banker  to  accept 
for  him  at  ninety  days'  sight.  The  banker,  we  will 
assume,  charges  one-quarter  of  one  per  cent  com- 
mission. When  the  business  man  has  obtained  the 
acceptance,  in  this  way,  he  has  arranged  a  means  of 
payment  for  his  creditor,  but  it  may  be  that  he  also 
wishes,  or  is  obliged,  to  provide  funds  for  his  creditor 
in  cash.  This  means  that  he  must  arrange  for  negotiat- 
ing or  discounting  the  bill.  He  must,  therefore,  find, 
or  have  some  agent  or  banker  find  for  him,  a  banking 
house  which  will  discount  the  paper.  Thus  a  discount 
is  added  to  the  acceptance  commission.  As  bankers' 
acceptances  are  reckoned  prime  paper,  certain  of  re- 
demption at  maturity,  and  in  many  cases  eligible  for 
rediscount  at  the  Reserve  banks,  it  is  usually  true  that 
the  acceptance  commission  plus  the  cost  of  discounting 
the  acceptance  is  quite  as  low  as  the  prevailing  rate  on 
commercial  paper,  and  usually  lower.  At  the  present 
time  in  the  New  York  market  there  is  often  a  rough 
correspondence  between  the  call  rate  and  the  accept- 
ance rate,  inasmuch  as  out-of-town  banks  which  have 
money  to  spare  are  able  to  choose  between  putting 
such  funds  into  call  loans  or  into  the  purchase  of 
acceptances.  There  is  thus  some  tendency  toward  an 
evening  up  of  rates.  The  general  principles  which 
control  in  each  of  these  branches  of  the  money  market, 
however,  are  the  same  as  those  which  obtain  in  others. 


194  BANKING  AND   BUSINESS 

Adjustment  of  rates  as  between  different  sections  of 
the  market,  such  as  straight  commercial  paper,  bankers' 
acceptances,  call  loans,  and  the  like,  is  very  prompt, 
and  while  these  rates  are  seldom  identical  with  one 
another,  the  difference  is  due  to  the  fact  that  what  is 
traded  in,  in  one  section  of  the  market,  is  not  quite  the 
same  as  what  is  traded  in  in  the  other.  There  is  a 
difference  in  the  degree  of  the  liquidity  or  availability 
of  the  funds. 

The  popular  supposition  that  as  business  declines 
"money"  or  ''funds"  are  "released"  from  employ- 
ment and  soon  become  available  for  stock-market 
operations,  thereby  tending  to  reduce  the  money  rate 
in  the  market,  is  erroneous.  There  was  a  modicum  of 
truth  in  it  so  long  as  our  currency  was  inelastic  and  so 
long  as  reserves  could  be  built  up  by  the  redeposit  of 
spare  resources  with  city  banks  which  promptly  lent 
them  to  investors  or  speculators.  None  of  these  con- 
ditions now  exists,  but  the  only  motive  for  the  placing 
of  funds  in  the  stock  market — apart  from  the  mere 
desire  to  take  care  of  a  bank  customer — is  the  wish 
to  earn  an  income.  Under  present  rates  of  discount 
about  as  much  can  be  made  by  placing  bank  funds  in 
acceptances  eligible  for  rediscount  with  reserve  banks 
as  can  be  obtained  in  the  stock  market.  Indeed,  during 
the  latter  half  of  1921  there  was  general  correspondence 
between  the  rate  on  acceptances  and  the  rate  to  be 
obtained  by  lending  in  the  stock  market.  That  there 
should  be  a  general  correspondence  between  these  rates 
and  the  actual  yield  on  thoroughly  good  investment 
securities  is  a  natural  outgrowth  of  the  situation. 

VIII.  Central-bank  Rate. 

In  countries  where  central  banking  exists  there  is  a 
central-bank  rate,  or  rediscount  rate,  which  is  different 


INTEREST  AND  DISCOUNT  RATES    195 

from  any  of  the  various  commercial  rates  just  described 
and  which  has  an  influence  upon  the  market  in  general 
that  is  of  a  quite  special  nature.  In  the  United  States 
the  central-bank  rate,  or  discount  rate,  is  the  rat<j  fixed 
by  the  Reserve  System.  It  differs  from  other  rates  in 
that  it  applies  only  to  a  certain  very  narrowly  limited 
paper,  while  it  is  made  only  in  favor  of  banks,  inas- 
much as  the  Reserve  banks  do  not  deal  with  indi\'iduals, 
but  only  with  banking  customers. 

The  question  how  the  rediscount  rate  is  fixed  and 
what  it  represents  is  one  as  to  which  there  is  a  very 
considerable  difference  of  opinion.  One  view  of  the 
matter  has  been  that  the  rediscount  rate  is  a  wholesaler's 
rate.  This  prevalent  theory  of  interest  rates  regards  the 
reserve  or  central  bank  as  a  wholesaler  of  credit,  while 
member  or  "commercial"  banks  may  be  conceived  of 
as  retailers.  The  retail  dealer  gets  his  "funds"  at, 
say,  7  per  cent.  He  retails  them  to  customers  at  a 
"profit"  of,  say,  about  7  per  cent,  making  his  rate 
7.49  per  cent,  or,  roughly,  l}/2  per  cent.  This  view  of 
the  case,  of  course,  ignores  that  what  the  retailer 
borrows  is  not  "funds,"  but  a  reserve  credit  which  vAW 
sustain  several  times  its  own  amount  of  "loans"  at 
a  conmaercial  bank.  Perception  of  this  fact  has  led 
some  hasty  thinkers  to  suggest  that  under  a  central 
banking  system  an  advance  in  the  rate  of  rediscount 
would  not  affect  the  commercial  rate  at  all  or  only  in 
a  negligible  way,  since  it  would  have  to  be  raised  several 
per  cent  to  produce  any  noticeable  change  in  interest 
rates  among  actual  loans  to  customers. 

The  fact  in  the  case,  of  course,  is  that  the  analogy 
of  wholesaler  and  retailer  is  thoroughly  false  as  a 
reflection  of  the  relation  between  reserve  bank  and 
commercial  bank.  No  bank  gets  its  entire  loanable 
funds  by  rediscounting ;  many  do  not  rediscount  at 
all.     The  normal  condition  is  perhaps  that  the  average 


196  BANKING  AND   BUSINESS 

bank  carries  a  moderate  rediscount  line  which  is  far 
less  than  its  ehgible  loans  and  discounts.  Accord- 
ingly, some  have  argued  that  while  the  average  bank 
pays  interest  (rediscount  rates)  on  only  a  part  of  its 
operations,  these  "marginal  transactions"  determine 
the  cost  of  the  whole  to  the  customer,  just  as  a  manu- 
facturer who  finds  he  can  get  his  materials  at  a  rising 
cost  establishes  a  uniform  charge  for  the  goods  which, 
if  possible,  is  based  on  the  "cost  of  replacement" — the 
amount  he  must  spend  to  get  additional  material  at  the 
rising  price.  The  trouble  with  this  theory  is  that  it 
does  not  correspond  to  facts.  Many  a  bank  has  car- 
ried its  customers  through  a  high-rate  period  without 
raising  interest  charges  at  all.  New  customers  are 
often  obliged  to  pay  a  rate  based  on  the  rediscount 
figure,  although  even  they  are  not  always  so  dealt 
with,  especially  where  the  lending  bank  was  not  obliged 
to  replenish  its  reserves  by  rediscounting  such  cus- 
tomer's paper. 

IX.  Central-bank  Rate  and  Credit  Policy. 

Rates  cannot  be  studied  to  advantage  without  also 
studying  the  general  problem  of  credit  policy.  Evi- 
dently, if  rates  were  raised  or  lowered  without  any 
reference  to  credit  policy,  they  would  be  a  minor 
influence.  If  the  Reserve  Bank  refused  to  rediscount, 
it  would  make  no  difference  what  rate  was  theoretically 
in  effect.  In  prewar  times,  under  British  practice,  the 
"rate"  was  the  cost  of  getting  a  reserve  credit  which 
was  hmited  only  by  the  amount  of  available  "eUgible" 
paper  that  could  be  presented.  During  the  war  the 
rates  then  fixed  imphed  a  readiness  to  lend  up  to  any 
amount  on  the  kind  of  paper — chiefly  government- 
obligations-collateraled  notes — which  constituted  the 
staple  of  bank  operations  at  that  time.     Since  the  war 


INTEREST  AND  DISCOUNT  RATES    197 

there  has  been  an  attempt  to  reduce  or  "ration"  credit, 
especially  those  forms  of  it  that  were  uncertain  of 
maturity  or  of  self-liquidation,  and  which  hence  con- 
stituted a  source  of  danger  in  respect  to  inflation.  The 
real  question  to-day,  in  so  far  as  the  commercial  rate 
for  money  is  concerned,  is  whether  there  has  been  a 
relaxation  of  credit  policy — a  change  in  the  attitude 
adopted  with  respect  to  rediscounting. 

This  outline  of  the  general  theory  and  practice  of 
central,  or  Reserve,  bank  rates  and  their  relation  to 
commercial  rates  should,  however,  be  regarded  as 
merely  the  general  statement  of  the  case.  In  individual 
instances  a  member  bank  which  at  the  time  is  "loaned 
up"  and  which  in  order  to  make  any  further  loans  to 
a  customer  is  obUged  to  rediscount  that  customer's 
l)aper  with  the  Reserve  Bank,  may  say  to  such  cus- 
tomer that  it  ^^'ill  not  lend  to  him  except  at  a  rate 
fixed  by  the  Federal  Reserve  Bank  plus  the  banker's 
own  indorsement  commission.  This,  however,  is  the 
exceptional  case.  But,  as  stated,  orcUnarily  no  such 
direct  connection  between  the  reserve  rat^s  and  those 
of  the  rank  and  file  of  the  banks  exists.  The  reserve 
rate  is  presumably  fixed  at  such  a  figure  as  will  result 
in  maintaining  a  fair  balance  between  the  outstanding 
liabilities  of  the  reserve,  or  central  bank,  and  its  cash 
assets.  As  the  rate  is  lowered  the  central  bank  theoret- 
ically stands  ready  to  rediscount  or  purchase  any 
amount  of  eligible  paper  that  may  be  offered  to  it. 
As  the  rate  is  advanced  the  amount  of  offerings  of 
paper  which  would  othermse  be  presented  is  cut  off 
because  the  profit  is  not  large  enough.  Thus  the  cen- 
tral bank  maintains  a  balance  between  the  amount  of 
o\'erdue  credit  available  and  the  cash  on  hand.  This 
is  the  theory  upon  which  the  Bank  of  England  has 
worked  for  many  years,  and  before  the  war  developed 
the  well-known  rule  that  the  rediscount  rate  should 


198  BANKING  AND   BUSINESS 

always  be  slightly  ahead  of  the  market  rate  That  is 
to  say,  if  funds  were  being  loaned,  say,  at  6  per  cent  in 
ordinary  bank  transactions  on  a  given  kind  of  paper, 
the  Bank  of  England  rate  would  be  perhaps  6^  per 
cent.  The  bank,  however,  always  reserved  the  right 
to  make,  and  did  habitually  make,  a  so-called  private 
rate  at  which  it  dealt  with  customers  as  it  saw  fit,  while 
it  stood  ready  to  take  any  amount  of  paper  at  the 
official  rate.  In  the  United  States  this  plan  has  been 
varied  and  Reserve  banks  make  only  one  rate  on  each 
kind  of  paper,  while  they  have  seldom  or  never  stood 
ready  to  take  unlimited  amounts  of  such  paper,  but 
have  kept  to  the  privilege  of  refusing  it  or  rejecting  it 
on  various  grounds.  The  result  has  been  that  the 
market  relationship  between  the  rediscount  rate  and 
the  commercial  rate  which  existed  in  England  before 
the  war  has  not  prevailed  in  the  United  States.  War 
finance  has  established  a  condition  which  probably 
would  have  made  a  reproduction  of  the  Bank  of 
England  poUcy  in  exact  terms  impossible.  As  it  stands 
to-day,  therefore,  the  Reserve  Bank  rate  may  be  de- 
scribed as  being  simply  the  rate  at  which  banks  may 
count  upon  being  able,  up  to  a  reasonable  figure,  to 
rediscount  certain  narrowly  limited  kinds  of  commer- 
cial paper  with  the  Reserve  Bank,  while  from  the  in- 
ternal standpoint  of  the  Reserve  Bank  the  rediscount 
rate  is  looked  upon  as  a  rate  which  comes  nearest 
to  establishing  a  proper  balance  or  relationship  between 
outstanding  liabilities  and  vault  cash.  It  cannot  be 
stated  that  there  is  no  direct  relationship  between 
either  market  rates  for  coimnercial  paper  or  call  rates, 
on  the  one  hand,  and  those  of  Reserve  banks,  on  the 
other.  Reserve  banks,  however,  have  established  rates 
which  vary  considerably  for  the  different  classes  of 
paper.  In  a  general  way  they  have  pursued  the 
principle  of  making  the  rates  higher  as  paper  grew 


INTEREST  AND  DISCOUNT  RATES    199 

longer,  higher  as  the  nature  of  the  loan  was  less  liquid, 
and  higher  according  as  the  paper  was  or  was  not 
thoroughly  protected  by  indorsements.  The  rate  has 
been  made  lower  for  shorter  paper,  lower  for  well- 
indorsed  paper,  and  lower  for  higlily  liquid  paper. 
Thus  bankers'  acceptances  have  usually  been  given 
the  lowest  going  rate,  while  the  highest  rate  has  been 
paid  for  long-term  agricultural  loans  of  a  maximum 
maturity  of  one  hundred  and  eighty  days.  Commer- 
cial paper  has  paid  the  highest  rate  for  ninety-day 
accommodation,  and  the  lowest  for  shorter  terms — 
sixty,  thirty,  or  fifteen  days.  During  the  earlier  years, 
after  the  organization  of  the  Reserve  system,  the  rats 
policy  was  highly  complicated  and  resulted  in  the 
establishment  of  many  rates,  varying  oftentimes  by 
almost  imperceptible  amounts  from  one  another.  The 
coming  on  of  the  war  and  the  establishment  of  special 
rates  designed  to  facilitate  the  sale  of  public  bonds 
tended  to  make  this  rate  policy  still  more  complex. 
Since  the  close  of  the  war  the  practice  has  been  con- 
siderably simplified,  and  the  tendency  to-day  at  most 
Reserve  banks  is  in  the  direction  of  a  limitation  of  the 
number  of  rates  that  are  made  and  toward  the  classi- 
fication of  paper  upon  rather  broad  lines. 

14 


CHAPTER  XIII 

BANKING  COSTS 

I.  Elements  of  Cost. 

In  the  preceding  chapter  the  sources  of  income  which 
are  ordinarily  open  to  a  bank  have  been  outUned,  and 
one  of  them — the  rate  of  interest  or  discount — has 
been  analyzed  at  some  length.  It  is  equally  important 
to  consider  with  care  the  various  elements  of  cost  which 
the  bank  is  obliged  to  incur.  Speaking  generally, 
these  elements  of  cost  may  be  summarized  as  follows: 

1.  Fixed  expenses — rent  (or  the  interest  on  invest- 
ment in  building  and  equipment),  insurance,  surety 
bonds,  taxes,  light,  heat,  etc. 

2.  Bad  debts. 

3.  Overhead  expenses — salaries  of  president  and 
general  officers  not  assigned  to  any  specific  duty. 

4.  Operating  salaries. 

5.  Stationery,  printing,  postage,  etc. 

6.  Allowance  for  interest  on  capital. 

7.  Depreciation  of  equipment  and  building. 

Most  of  these  expenses  are  sufficiently  obvious  to 
require  no  description  or  explanation.  The  bank,  of 
course,  must  have  some  definite  quarters  and  it  gets 
these  either  by  hiring  them  from  others  or  by  purchas- 
ing or  building  them.  In  any  case  there  is  either  an 
annual  outlay  or  a  capital  sum  on  which  interest  must 
be  allowed  which  represents  the  cost  of  the  bank's 
quarters  or  offices.    In  the  same  way  the  fixed  ex- 


BANKING  COSTS  201 

penses  for  lighting,  heating,  and  caring  for  the  offices 
of  the  bank  must  be  provided  for,  and  may  be  regarded 
as  a  fixed  sum  in  a  degree  independent  of  the  total 
amount  of  business  the  bank  has  to  do  and  in  a  large 
measure  independent  of  the  amount  of  its  capital. 

The  overhead  expenses  are  in  somewhat  the  same 
class  as  these  fixed  or  plant  expenses.  Every  bank 
has  a  certain  number  of  salaried  officers  whose  work 
when  well  done  is  of  utmost  importance  to  the  institu- 
tion, but  whose  pay  cannot  be  assigned  to  any  particu- 
lar undertaking.  They  are  ''overhead"  in  the  sense 
that  they  belong  to  or  must  be  charged  against  every- 
thing beyond  bank  debts  in  due  proportion — that  is 
to  say,  they  are  salaries  which  are  practically  incident 
to  the  doing  of  any  business  and  which  have  only  a 
secondary  relationship  to  the  amount  of  such  business. 
We  shall  presently  see  how  the  cost  of  such  salaries  is 
usually  distributed  among  the  different  factors  or 
divisions  of  the  organization. 

II.  Operating  Expenses. 

When  we  come  to  the  operating  expenses  of  the  bank, 
and  to  the  cost  of  the  capital  involved,  a  very  dif- 
ferent situation  exists.  The  larger  part  of  the  bank's 
expenses  for  regular  operation  is  found  in  the  salaries 
of  its  operating  staff  and  in  the  allowance  that  has  to 
be  made  for  the  amount  of  capital  requii'ed  to  sustain 
such  operations.  In  every  bank,  therefore,  which  at- 
tempts to  keep  track  of  its  costs  with  any  degree  of 
care  or  to  apportion  such  costs,  there  is  an  effort  to 
segregate  outlays  by  departments.  Earlier  in  the  pres- 
ent volume  the  internal  organization  of  the  bank  has 
been  described  and  it  has  there  been  pointed  out  that 
a  number  of  independent  departments  can  be  recog- 
nized.    Let  us  take,  for  example,  the  paying  teller's 


202  BANKING   AND   BUSINESS 

department.  In  that  division  there  is  a  fairly  distinct 
segregation  of  work,  and  it  is  possible  to  decide  prac- 
tically what  salaries  are  assignable  to  the  task  of  meet- 
ing the  bank's  obligations  over  the  counter.  This,  of 
course,  does  not  allow  for  the  pro-rata  share  of  the 
bookkeeping  which  grows  out  of  the  paying  teller's 
duties,  but  that  is  comparatively  easily  assignable  after 
a  method  which  will  presently  be  described.  It  is, 
therefore,  entirely  possible  to  segregate  and  analyze 
the  cost  of  the  paying  teller's  transactions  and,  if 
desired,  to  complete  this  cost  by  figuring  in  the  cost  of 
the  bookkeeping  that  grows  out  of  it.  If  desired,  too, 
there  can  from  this  aggregate  be  computed  the  cost 
to  the  bank  of  paying  each  individual  check  or  the  cost 
of  paying  checks  per  $1,000. 

III.  Overhead  Expenses. 

Of  course,  all  this  has  taken  no  account  of  the  over- 
head expenses  or  the  fixed  expenses.  There  is  naturally 
no  definite  or  positive  way  of  segregating  and  assigning 
them,  and  yet  it  is  reasonable  to  make  a  distribution 
of  fixed  expenses  on  the  basis  of  floor  space  occupied, 
or  some  similar  principle,  while  it  is  equally  possible  to 
distribute  overhead  charges  on  the  basis  of  total 
operating  outlay  or  some  plan  of  the  same  sort.  ^Mien 
the  distribution  has  been  made  in  this  way  the  result 
is  to  give  a  surcharge  which,  when  added  to  the  actual 
operating  expenses  of  the  department,  represents  a 
total  theoretical  department  outlay  which  may  then  be 
assigned  to,  or  divided  among,  the  different  operations 
carried  on  in  the  department.  Thus,  for  example, 
suppose  that  the  pro-rata  share  of  fixed  and  overhead 
expenses  chargeable  to  the  paying  teller's  department 
in  a  specified  bank  is  $10,000,  while  the  salaries  of  that 
department  may  be  figured  at,  say,  $90,000.     Here  the 


BANKING  COSTS  203 

total  expenses  of  the  department  would  be  considered 
as  $100,000.  A  like  method  of  computation  may  be 
followed  throughout  the  whole  of  the  institution.  For 
example,  suppose  that  the  institution  is  divided  into 
some  five  or  six  different  groups,  or  sections,  or  de- 
partments, the  sum  total  of  the  charge  to  the  depart- 
ment for  fixed  and  overhead  expenses  when  added 
gives  the  aggregate  outlay  for  overhead  and  fixed 
items,  while  as  divided  as  among  the  different  branches 
of  work  it  represents  the  individual  addition  to  their 
operating  cost.  It  is  now  possible  to  get  at  least  an 
approximate  notion  of  the  total  expense  involved  in 
playing  checks,  or  in  receiving  deposits,  or  in  collecting 
items,  and  this  may  be  assigned  on  the  basis  of  number 
of  operations  performed — thus  getting  an  approximate 
estimate  of  the  cost  of  collecting  a  check,  paying  a 
check,  receiving  a  deposit,  clearing  a  check,  etc.  It  is 
clear  that  the  problem  involved  in  this  kind  of  appor- 
tionment or  computation  is  a  simple  form  of  cost 
analysis  or  cost  accounting,  which  merely  involves  the 
apportionment  or  assignment  of  elements  of  outlay  to 
the  purposes  or  operations  which  give  rise  to  them. 

IV.  Determination  of  Cost  per  Unit. 

Thus  far  the  analysis  is  comparatively  an  easy  one 
even  if  the  results  obtained  are  not  much  more  than 
approximate.  Now,  however,  it  is  necessary  to  recog- 
nize that  there  is  nothing  fixed  about  bank  expense  or 
bank  cost  in  so  far  as  refers  to  individual  transac- 
tions. This  is  because  the  volume  of  operations  han- 
dled determines  the  cost  per  unit  up  to  the  point  where 
it  is  necessary  to  add  further  elements  of  cost.  For 
instance,  suppose  that  a  given  staff  of  men  in  the 
paying  teller's  department  can  pay  five  thousand 
checks   a   day.     Suppose,   however,    that   the   bank's 


204  BANKING  AND   BUSINESS 

clientele  is  not  of  a  kind  which  habitually  presents 
many  checks  for  cashing;  so  that,  as  a  matter  of  fact, 
not  more  than  five  hundred  to  a  thousand  are  daily 
presented  for  payment.  Inasmuch  as  the  bank  must 
maintain  a  complete  and  well-organized  staff  in  that 
department,  it  would  seem  that  the  expense  of  handling 
each  one  of  these  checks  is  anywhere  from  five  to  ten 
times  as  great  as  if  the  staff  were  working  at  capacity. 
In  the  same  way,  imagine  the  case  of  an  institution 
which  is  equipped  and  able  to  handle  collections  run- 
ning into  a  given  number  of  thousand  items  daily — 
say,  ten  thousand  items.  Clearly,  if  its  depositors  only 
bring  it  five  thousand  items  daily  the  proportionate 
expense  of  the  collection  department  is,  relatively 
speaking,  very  high.  This  peculiarity  of  banking  is 
the  same  that  is  to  be  noted  in  the  case  of  public- 
service  corporations.  Suppose  a  street-car  line  is 
obliged  to  run  a  car  over  a  given  route  at  least 
once  in  five  minutes.  Experience  shows  that  a  car 
run  once  in  ten  minutes  will  be  comfortably  filled, 
but  a  more  frequent  operation  of  cars  does  not  result 
in  a  corresponding  increase  of  passengers,  so  that  each 
car  is  not  more  than  half  full.  Here  the  more  frequent 
service  is  simply  so  much  added  expense.  Economy  in 
operating  the  bank  is  likewise  found  in  adapting  the 
size  of  the  staff  to  the  average  volume  of  its  items  in 
each  department — first  ascertaining  from  experience 
about  what  customers  will  require,  then  enlarging  or 
contracting  the  staff  in  each  branch  to  correspond 
thereto.  Even  when  this  has  been  done,  however,  the 
variation  in  costs  will  be  a  very  great  one.  Suppose, 
for  example,  that  a  large  bank,  whose  customers  seldom 
present  checks  for  cashing,  has  a  small  stafT  of  men  in 
the  paying  teller's  department.  Suppose,  further,  that 
this  small  staff  has  its  time  fully  occupied  even  with  the 
limited  number  of  checks  which  come  through.     Con- 


BANKING   COSTS  205 

trast  with  this  bank  the  case  of  another  in  which  a  very 
large  volume  of  payments  is  daily  made  and  a  corre- 
spondingly large  staff  employed.  The  chances  are 
that  the  cost  of  pajdng  a  check  in  the  bank  with  the 
large  volume  of  payments  will  be  very  much  less  than 
in  the  other.  This  makes  it  difficult  to  hit  upon  any 
standard  scale  of  banking  costs  proportionate  to 
operation. 

V.  Reserve  as  an  Item  of  Cost. 

Even  allowing  for  difficulties  inherent  in  fluctuations 
in  volume  of  banking  operations,  however,  the  problem 
of  ascertaining  costs  per  unit  of  business  done  might  not 
be  considered  very  complex  by  the  cost  accountant — 
at  least  in  theory.  There  are  other  elements,  however, 
in  the  bank's  business  which  present  considerably  more 
difficult  problems.  The  most  important  of  these  is 
probably  that  which  centers  around  the  question  of 
reserves.  As  we  have  seen  in  an  earlier  portion  of  this 
volume,  every  bank  is  obliged,  either  by  custom  or  law, 
or  by  both,  to  maintain  a  certain  reserve.  For  the  sake 
of  ease  in  figuring,  we  may  assume  that  this  reserve  is 
20  per  cent  of  its  outstanding  liabilities.  Now,  when 
A  brings  to  the  bank  a  deposit  in  coin  amounting  to 
SI, 000,  the  bank  establishes  in  his  favor  a  credit  on  its 
books  of  $1,000,  while  it  places  in  its  cash  reserve  the 
$1,000  in  coin.  It  is  evident  that  if  the  bank  must 
keep  a  reserve  of  20  per  cent  behind  its  outstanding 
deposits,  $200  of  the  coin  which  is  thus  received  must 
be  maintained  permanently  on  hand  in  its  vault  to 
protect  the  outstanding  credit  of  $1,000.  This  means 
that  it  has  $800  of  free  cash.  It  may  theoretically  lend 
this  $800  to  borrowers.  Suppose,  for  the  sake  of 
argument,  that  it  does  so,  how  does  the  position  of 
the  bank  then  stand?    It  owes  A  $1,000,  while  it  has 


206  BANKING  AND   BUSINESS 

lent  $800  to  B  at,  say,  6  per  cent.  If  it  pays  no  in- 
terest to  A  it  is  now  the  gainer  by  the  transaction  by 
6  per  cent  on  $800,  or  at  a  rate  of  $48  per  annum. 
From  this  must  be  deducted  the  expense,  what^ever  it 
may  be,  which  has  been  found  by  experience  to  repre- 
sent the  cost  of  carrying  a  deposit  account  and  of  paying 
checks  which  are  customarily  drawn  upon  it.  There 
must  also  be  taken  off  the  expenses  involved  in  making 
the  loan  to  B,  which  include  an  investigation  of  his 
credit  and  a  variety  of  other  items,  to  say  nothing  of 
the  overhead  and  fixed-expense  charge  applicable  to 
all  transactions  of  the  bank.  After  these  have  been 
deducted  from  the  $48,  a  net  profit  presumably  re- 
mains. The  bank,  however,  does  not  do  business  in 
this  way  customarily,  but  it  holds  the  $800  in  its 
vaults  as  a  reserve.  Customers  do  not  habitually 
borrow  in  cash,  and  if  they  did  the  bank  would  soon 
refuse  to  do  business  with  them.  If  the  $800  be  re- 
garded as  a  20-per-cent  reserve,  it  is  evident  that  the 
bank  might  credit  on  its  books  liabihties  equal  to  five 
times  that  amount — that  is  to  say,  it  could  undertake 
to  credit  to  depositors  the  sum  of  $4,000  and  j^et  be  in 
a  safe  position,  because  it  would  have  on  hand  in  its 
vaults  the  20-per-cent  protection  referred  to.  The 
basic  income  upon  which  interest  would  have  to  be 
figured  would  not  be  6  per  cent  on  $800,  but  on  $4,000, 
or  $240.  Deductions  as  before  w^ould  have  to  be  made 
from  this  profit,  covering  the  loans  that  had  been 
made  in  order  to  get  it,  and  covering  also  the  other 
items  of  expense  connected  with  it. 

How  safe  would  the  bank  be  in  this  position?  It 
would  have  outstanding  $5,000  in  deposit  accounts,  or 
deposit  credits,  and  would  have  in  its  vaults  $1,000 
in  coin.  The  question  of  its  safety  would  depend 
largely  upon  the  question  whether  it  was  receiving 
checks  from  depositors  about  as  fast  as  it  was  pajdng 


BANKING  COSTS  207 

checks  drawn  on  deposit  liabilities  which  it  had  thus 
credited.  In  other  words,  it  could  not  regard  itself 
as  doing  a  safe  business  at  all  unless  there  was  a  steady 
flow  of  funds  into  the  bank  which  fully  offset  the  flow 
of  funds  out  of  it.  Of  course  a  certain  percentage — 
perhaps  a  large  percentage — of  the  checks  drawn  on 
the  $5,000  of  deposit  accounts  would  be  drawn  in 
favor  of  persons  who  would  redeposit  them  in  the 
bank  itself,  in  which  case  the  expense  would  be  simply 
the  maintenance  of  the  bookkeeping  department.  A 
good  many,  however,  would  be  drawn  in  favor  of  other 
banks,  and  would  have  to  be  cashed.  If  their  cashing 
resulted  in  loss  of  specie  the  bank  would  soon  find 
itself  back  at  the  position  in  which  it  could  maintain 
outstanding  only  an  amount  of  loans  equal  to  the 
amount  of  specie — the  original  $800.  But  on  condi- 
tion that  it  keeps  expanding  its  business  and  gets  in 
as  many  checks  as  it  pays,  it  can  keep  outstanding  a 
volume  of  loans  represented  by  deposits  on  which  it 
receives  interest.  This  amount,  as  we  have  seen,  is 
conditional  upon  its  keeping  up  an  active,  live  business 
with  a  steady  movement  of  items  into  and  out  of  the 
bank. 

By  this  time  it  is  clear  that  the  assignment  of  costs 
to  each  particular  unit  of  cash  that  comes  into  the 
hands  of  the  bank  is  very  difficult.  Thus,  for  instance, 
in  the  illustration  that  we  have  given  we  assume  that 
the  original  depositor  paid  in  $1,000  and  received  a 
credit  on  the  bank's  books  without  interest.  This  cash 
was  then  used  as  a  reserve  and  loans  were  made 
thereon,  giving  rise  to  deposit  liabilities,  while  finally 
we  saw  that  the  maintenance  of  these  deposits  was 
conditional  upon  the  bank's  doing  an  active  collection 
business.  To  trace  the  expense  of  all  of  these  trans- 
actions back  to  the  original  deposit  of  SI, 000  in  coin, 
and  so  to  estimate  what  that  dejwsit  was  worth  to  the 


208  BANKING  AND   BUSINESS 

bank,  is  practically  out  of  the  question.  As  a  result 
most  banks  which  do  anything  in  the  way  of  cost 
accounting  simply  endeavor  to  ascertain  the  expense 
involved  in  performing  certain  representative  bank 
transactions,  such  as  paying  checks,  collecting  checks, 
etc.,  and  they  then  seek  to  estimate  the  worth  of  any 
given  account  to  them  upon  an  expense  basis.  They 
usually  make  no  distinction  of  the  form  in  which  depos- 
its are  made — whether  in  coin,  claims  on  other  banks,  or 
checks  on  the  bank  itself.  It  is  enough  for  them  that  a 
credit  has  been  established  on  their  books,  and  their 
effort  then  is  to  find  out  about  what  the  current  cost 
of  carrying  on  such  a  deposit  account  is.  Neverthe- 
less, it  is  true  that  underlying  every  loan  that  gives 
rise  to  a  deposit  is  the  item  of  reserve  carried  against  it. 
We  have  seen  that  in  the  case  of  the  illustration  already 
given  this  reserve  was  20  per  cent.  On  every  out- 
standing deposit  made  by  the  bank,  therefore,  it  would 
be  proper  to  figure  the  "tying  up"  of  20  per  cent  of  the 
amount  of  the  deposit.  For  instance,  if  A  borrows 
from  the  bank  $1,000  at  6  per  cent  per  annum,  and  if 
the  bank  habitually  gets  a  flow  of  checks  which  offsets 
the  checks  drawn  by  A,  it  might  be  assumed  that  the 
profit  of  the  bank  was  the  interest  at  6  per  cent  on 
$1,000,  or  $60,  minus  the  expense  involved  in  keeping 
open  a  deposit  of  that  amount,  minus  such  assignment 
of  overhead  charges  as  the  bank  might  determine  to 
make.  This  amount  would  be  only  a  part  of  the  truth. 
It  would  still  be  true  that  the  bank  was  obliged  to 
figure  upon  having  to  put  $200  out  of  its  power  to  use 
that  sum,  since  it  is  obliged  to  hold  that  as  a  reserve. 
While  it  does  not  cost  anything  directly  to  employ  its 
capital  in  this  way,  the  indirect  cost  is  the  interest  on 
$200  at  the  going  rate.  Every  transaction  on  the  part 
of  the  bank,  then,  which  involves  the  creation  of  a 
liability  involves  also  the  creation  of  a  reserve  and 


BANKING   COSTS  209 

results  in  a  corresponding  reduction  of  the  bank's 
available  funds,  properly  giving  rise,  therefore,  to  the 
corresponding  element  of  charge  against  income. 

This  may  be  a  very  varying  charge.  The  bank  may 
not  find  it  necessary  to  keep  its  whole  reserve  in  coin. 
Under  the  central  banking  system  it  may  be  able  to 
keep  its  reserve  with  some  other  bank,  which  results 
in  cutting  down  the  total  amount  of  reserve  required, 
or  it  may  be  disposed  to  invest  its  reserve  partly  in 
very  quick  paper.  Under  the  old  national  banking 
system  a  large  part  of  the  reserves  of  American  banks 
was  carried  on  interest  with  city  banks.  Conditions 
of  these  kinds  may  result  in  reducing  the  unit  reserv^e 
cost  of  conducting  the  institution.  The  result  is  still 
further  to  complicate  the  cost  analysis  of  the  bank's 
operations  and  to  make  it  difficult  in  any  given  case 
to  ascertain  the  exact  cost  of  a  given  transaction. 

VI.  Methods  of  Limiting  Cost  of  Accounts. 

Nevertheless,  there  are  some  principles  which  stand 
out  so  clearly  in  this  kind  of  cost  analysis  as  to  make  it 
possible  to  limit  costs  quite  definitely.  For  instance, 
assuming  that  every  loan  is  made  only  after  a  careful 
credit  analysis  of  the  concern  which  applies  for  it,  it  is 
clear  that  very  much  the  same  amount  of  investigation 
must  be  made  in  order  to  lend  with  entire  safety 
$10,000  to  a  concern  that  would  have  to  be  made  if  the 
loan  were  S25,000.  In  the  same  way  it  evidently 
costs  about  as  much  for  a  bank  to  pay  a  check  of  SlOO 
as  it  does  to  pay  a  check  of  SI.  The  banker  can, 
therefore,  to  some  extent  limit  himself  by  prescribing 
the  size  of  the  transactions  which  he  will  undertake. 
He  may  make  what  amounts  to  a  fixed  rule  that  no 
loans  shall  be  made  under  ordinary  circumstances  below 
a  given  amount,  or  that  he  does  not  expect  his  cus- 


210  BANKING  AND   BUSINESS 

tomers  to  draw  checks  below  a  certain  amount.  More 
important  still,  he  may  inform  his  customers  that  they 
nmst  keep  on  deposit  with  him  a  minimum  balance  in 
an  amount  whose  interest  is  estimated  to  about  carry 
the  cost  of  their  business  transactions.  In  all  of  these 
ways  he  may  seek  to  cut  down  an  excessive  volume  of 
transactions  and  thereby  to  reduce  the  expenses  con- 
nected with  them,  especially  in  those  cases  where  the 
volume  of  business  is  in  very  small  units  and  represents 
a  kind  of  transaction  that  is  unproductive  or  unre- 
munerative.  Having  fixed  these  broad  general  limita- 
tions upon  his  business,  the  banker  can,  thereafter,  guard 
himself  only  by  careful  and  constant  analysis  of  each 
account  in  order  to  make  sure  whether  it  is  profitable 
or  not.  In  so  doing  he  ascertains  the  amount  of  the 
various  kinds  of  work  which  he  has  to  do  in  keeping  the 
account  going — the  number  of  checks  paid  and  the 
various  other  items  of  accommodation  asked  for  by  the 
customer.  Particularly  does  he  seek  to  assure  himself 
that  the  account  is  a  live  one — that  is  to  say,  that  it 
consists  of  funds  which  are  actually  in  hand  and  not 
funds  that  are  merely  in  process  of  being  collected  or 
likely  to  come  in  at  some  time  in  the  future.  If  the 
account  is  merely  a  nominal  sum  composed  of  collection 
items  against  which  the  customer  is  constantly  drawing, 
the  banker  may  be  safe  enough,  but  he  is  simply  sup- 
plying his  customer  with  money.  In  such  a  case  the 
banker's  protection  is  merely  that  of  requiring  his 
customer  not  to  draw  against  any  balance  that  has  not 
been  actually  collected. 

VII.  ExTEKNAL  Items  of  Cost. 

The  principal  items  of  expense  outside  of  the  bank 
which  must  be  figured  upon  are  exchange  or  collection 
charges  to  other  banks  and  interest  paid  to  other  banks 


BANKING  COSTS  211 

and  to  depositors.  If  the  banker  is  obliged  to  redis- 
count— that  is  to  say,  to  borrow  from  other  institu- 
tions— the  cost  of  such  operations  must,  of  course,  also 
be  reckoned  in.  But  supposing  that  the  banker  is  self- 
dependent,  the  two  items  already  named  are  the  prin- 
cipal ones  for  which  he  must  provide.  In  looldng  over 
the  profitableness  of  an  account,  therefore,  he  first 
ascertains  the  internal  cost  of  carrying  it  along,  and 
then,  so  far  as  practicable,  assigns  his  external  costs 
to  the  accounts  which  give  rise  to  them.  This  gives 
him  a  fair  working  notion  of  the  advantage  or  dis- 
advantage involved  in  the  particular  class  of  business, 
or  in  the  particular  customer's  trade.  He  is  then  able 
to  apply  such  corrective  measures  in  those  cases  where 
loss  is  being  incurred  as  he  may  think  fit.  Unfortu- 
nately, it  is  a  fact  that  in  a  large  number  of  smaller  and 
medium-sized  institutions  cost  anal3^sis  of  the  kind 
briefly  outlined  in  this  chapter  is  not  very  carefully 
undertaken.  Many  banks  tend  to  work  by  a  sort  of 
"  rule-of- thumb  "  method,  and  to  make  up  on  one  item 
of  business  what  they  lose  on  another,  being  satisfied 
to  take  the  general  run  of  things  as  it  goes  and  ' '  average 
up." 

VIII.  Significance  of  Cost  Analysis. 

Remembering  that  bankers  find  it  difficult  to  fix 
rates  of  interest,  these  being  established  largely  on  a 
competitive  basis,  the  importance  of  carefully  watch- 
ing the  cost  in  the  bank  is  evident.  The  banker's 
income  is  fairly  well  established,  and  while  he  can 
increase  it  in  some  particulars  through  excellent  manage- 
ment and  by  taking  advantage  of  varying  rates  of 
interest  in  varying  communities,  his  principal  avenue 
of  success  is  found  in  increasing  his  volume  of  business. 
This,  however,  is  beneficial  only  if  he  keeps  his  costs 


212  BANKING  AND   BUSINESS 

down.     Banking  profit  is  thus  essentially  a  problem  of 
cost  analysis. 

All  this  is  of  interest  to  the  banker,  but  its  interest 
to  the  business  man  who  is  a  customer  of  the  bank  may 
not  be  so  clear.  The  business  man,  however,  finds 
that  the  banker's  regulations  and  requirements  result 
in  throwing  upon  him  various  items  of  cost  which  he 
had  not  reckoned  upon.  For  instance,  if  the  banker 
insists  that  he  shall  draw  only  against  collected  funds, 
the  business  man  is  practically  obliged  to  require  of  his 
customers  payment  in  a  certain  kind  of  exchange,  or 
else  to  reconcile  himself  to  the  loss  of  interest  on  the 
funds,  or,  in  order  to  offset  this  increase,  his  price  is 
raised  correspondingly  for  his  goods.  He  thus  soon 
learns  to  bring  himself  into  harmony  with  the  require- 
ments of  good  banking  in  order  to  reduce  his  own  costs. 


CHAPTER   XIV 
PUBLIC  REGULATION  OF  BANKING 

I.  Government  Control  of  Banking. 

The  subject  of  government  supervision  was  given 
some  consideration  in  Chapter  V,  which  studied  the 
bank  as  a  type  of  business  organization.  It  was  there 
noted  that  banks  are  subject  to  practically  all  the  legal 
restrictions  applying  to  other  corporations,  and  besides 
must  comply  viith  a  number  of  special  regulations. 
These  additional  limitations  are  justified  by  the  singu- 
lar nature  of  the  banking  business.  Banks  in  a  way 
are  quasi-public  enterprises,  for  through  their  ability 
to  extend  or  withhold  credit  they  influence  the  progress 
of  all  other  industries.  A  bank  differs  from  an  ordinary 
business  in  that  it  is  not  a  single  unit  whose  success 
or  failure  is  of  little  concern  to  other  banks,  but,  on 
the  contrary,  its  welfare  vitally  affects  all  of  them, 
since  each  institution  is  an  int-egral  part  in  the  credit 
structure  which  to  a  certain  extent  becomes  impaired 
by  even  one  failure.  For  this  reason,  because  of  the 
public  nature  of  their  business,  bankers  themselves 
have  realized  the  need  of  government  supervision. 
Government  supervision  is  particularly  essential  in  the 
United  States.  In  this  country,  very  few  banks  have 
been  permitted  to  establish  branches,  and  concentra- 
tion into  a  small  group  of  financial  institutions  has  been 
restrained.  Instead,  encouragement  has  been  given 
to  the  development  of  small  independent  banks,  and 
their  total  number  is  now  over  30,000.    Supervision  is 


214  BANKING  AND   BUSINESS 

more  readily  obtained  in  a  system  of  a  few  consolidated 
institutions  than  among  a  mass  of  many  banks  operat- 
ing under  varying  conditions  throughout  the  country. 

Government  supervision  aims  to  protect  stockholders, 
noteholders,  and  depositors  of  banks  by  seeing  that 
these  institutions  observe  the  principles  of  solvency 
and  liquidity.  In  general,  the  solvency  of  any  business 
depends  upon  the  adequacy  of  resources  in  meeting 
Uabilities.  When  the  obUgations  exceed  the  assets  of 
the  corporation,  the  situation  may  be  met  by  drawing 
upon  the  capital  investments,  but  this  impairment 
brings  loss  to  the  stockholders.  The  maintenance  of 
solvency  is  thus  a  problem  which  confronts  every 
business  enterprise.  In  addition,  a  bank  carries  the 
responsibiUty  of  continually  retaining  its  assets  in  a 
state  of  liquidity.  At  all  times  it  must  be  able  to  pay 
the  demand  claims  of  its  creditors,  whether  depositors 
or  noteholders.  A  bank  may  be  in  a  solvent  condition, 
but,  nevertheless,  its  assets  may  not  be  sufficiently 
liquid  to  satisfy  the  immediate  demands  of  its  creditors. 
If  the  bank  can  tide  over  this  temporary  embarrass- 
ment, its  assets  may  have  sufficient  permanent  value 
in  the  end  to  prevent  dissolution.  The  solvency  and 
liquidity  of  banks  are  thus  determined  by  different 
factors.  The  former  is  shown  largely  by  the  proportion 
of  the  capital  investment  to  general  liabihties,  while  the 
latter  is  based  upon  the  ratio  of  a  reserve  of  Hquid  as- 
sets to  demand  obligations.  In  regulating  banks  the 
government  can  develop  their  solvency  by  exacting  an 
adequate  contribution  of  capital  and  sm-plus,  and  their 
hquidity  by  insisting  upon  the  maintenance  of  a  suffi- 
cient reserve.  The  government  also  requires  that  assets 
in  general  be  satisfactory  in  character  and  that  loans 
in  particular  be  sound. 

To  attain  these  ends,  national  and  state  governments 
have    established    administrative    bodies    and    have 


REGULATION   OF   BANKING         215 

enacted  legislative  regulations.  The  federal  regulations 
are  well  codified  in  the  National  Bank  and  Federal 
Reserve  acts,  but  there  is  little  uniformity  in  the  bank- 
ing legislation  of  the  various  stat<is.  A  striking  com- 
parison is  found  between  the  banking  laws  of  New 
York,  which  contain  280  pages,  and  the  statutes  of  a 
state  hke  Arizona,  which  include  but  12  pages.  The 
national  and  state  regulations  cover  the  following  sub- 
jects: (1)  procedure  for  estabhshing  a  new  bank,  (2) 
requirements  of  capital  and  surplus,  (3)  restrictions  on 
granting  of  loans,  (4)  security  for  circulating  notes 
(national  only),  (5)  report  of  financial  condition,  (6) 
examination  of  banks,  (7)  maintenance  of  reserves 
against  deposits,  (8)  liquidation  of  insolvent  banks,  (9) 
procedure  in  the  event  of  failure  to  meet  the  require- 
ments of  the  laAv. 

The  procedure  for  establishing  a  new  bank  and  cap- 
ital requirements  have  been  already  discussed  in 
Chapter  V,  restrictions  on  loans  have  been  considered 
in  Chapter  VIII,  and  a  discussion  of  others  ^\'ill  be  de- 
ferred until  later.  Some  of  the  remaining  subjects  will 
now  be  treated  in  so  far  as  they  relate  to  commercial 
banks.  Government  regulation  of  noncommercial 
institutions  will  be  considered  in  Part  III. 

II.  Supervision  of  Banks. 

During  the  Civil  War,  Congress  passed  the  National 
Bank  Act,  which  provided  for  the  organization  and 
operation  of  banks  under  federal  law.  The  Act  created 
the  office  of  Comptroller  of  the  Currency.  This  title 
is  really  a  misnomer,  for  the  function  of  this  officer  is 
not  so  much  the  regulation  of  currency  issues  as  the 
supervision  of  banking  operations.  His  monetary 
duties  are  confined  merely  to  routine  mattei*s  relating 
to  the  issuing  and  redemption  of  notes  circulated  by 


216  BANKING  AND  BUSINESS 

national  and  Federal  Reserve  banks,  while,  on  the  other 
hand,  he  exercises  extensive  control  over  banks,  for  he 
possesses  the  sole  right  to  authorize  their  organization, 
and  even  to  close  them  if  conditions  warrant  such 
action.  He  requires  them  to  submit  periodic  reports 
concerning  their  financial  condition,  and  he  conducts 
examinations  of  their  resources  and  liabiUties. 

The  states  also  exercise  supervision  over  banks 
organized  under  local  laws.  A  few  exert  control  over 
banks  through  boards  composed  of  several  state 
officials,  and  the  function  of  examination  is  delegated 
to  the  same  department  which  investigates  other 
financial  institutions,  such  as  insurance  companies. 
It  is  more  customary  to  confer  the  supervision  upon  a 
single  officer  known  as  commissioner  or  superintendent, 
and  to  conduct  a  separate  department  concerned 
exclusively  with  the  supervision  of  banks  located  within 
the  state. 

III.  Reports. 

In  the  United  States,  government  regulation  of 
business  enterprises  is  rendered  more  effective  by  pro- 
viding for  some  form  of  publicity.  The  data  thus 
presented  enables  the  public  to  pass  its  own  judgment 
on  the  operations  of  the  business  under  consideration. 
Accordingly,  national  and  state  banks  are  required  to 
submit  several  kinds  of  reports,  the  most  important  of 
which  is  the  general  statement,  which  presents  a  sum- 
mary of  the  bank's  condition  on  a  particular  day.  In 
former  years,  the  supervising  officials  called  for  these 
reports  on  stated  dates  throughout  the  year.  Some 
banks  were  thus  able  to  arrange  affairs  so  that  their 
statements  would  present  an  excellent  shomng  on  the 
day  when  reports  had  to  be  submitted.  To  prevent 
this  "window  dressing"  the  Comptroller  now  sets  a 


REGULATION   OF  BANKING         217 

time  unknowTi  beforehand  to  bank  officers  by  calling 
for  a  statement  of  condition  on  a  day  which  has 
already  elapsed.  For  example,  on  July  3d  the  Comp- 
troller might  notify  all  national  banks  to  state  the 
amount  of  their  assets  and  habilities  on  June  2Gth. 
These  reports  must  be  attested  by  an  officer  and  cer- 
tain directors  of  the  bank  and  submitted  within  five 
days  after  the  call  has  been  issued.  The  National 
Bank  Act  requires  the  fiUng  of  at  least  five  reports 
thi'oughout  the  year. 

Similar  reports  are  also  required  by  the  state  govern- 
ments of  state  banks  and  trust  companies.  There  is 
close  co-operation  in  this  matter  in  some  states,  and  a 
number  of  state  superintendents  fix  the  call  for  reports 
on  the  same  day  as  that  set  by  the  federal  Comptroller. 
With  national  and  state  institutions  thus  reporting  on 
the  same  day,  it  is  possible  to  make  a  more  uniform 
study  of  financial  conditions  throughout  the  country. 
A  summary  of  the  statement  must  be  pubhshed  by 
each  bank  in  the  local  press  in  order  to  assure  publicity. 

In  addition  to  the  statement  of  general  condition, 
national  banks  are  called  upon  to  file  two  special  re- 
ports. Twice  a  year  they  must  submit  data  concern- 
ing the  amount  of  dividends  which  have  been  declared 
and  the  net  earnings  in  excess  of  these  dividends.  If  a 
national  bank  exercises  the  right  of  issuing  notes,  a 
report  must  be  also  made  on  the  amount  of  these 
obligations  in  circulation  on  January  1st  and  July  1st 
of  each  year.  On  certain  occasions  the  Comptroller  of 
the  Currency  has  requested  the  banks  to  submit  reports 
on  special  subjects. 

IV.  Government  Examinations. 

Bank  reports  alone  would  be  insufficient  to  safeguard 
the  interests  of  stockholders  and  creditors,  for  these 


218  BANKING  AND   BUSINESS 

statements  are  compiled  by  the  banks  themselves  and 
are  not  verified  by  any  outside  agency.  Moreover, 
mere  figures  fail  to  present  a  true  insight  into  the  con- 
dition of  the  reporting  banks.  To  verify  these  state- 
ments and  to  investigate  the  actual  status  of  the  banks, 
several  kinds  of  examinations  are  conducted.  They 
may  be  external  or  internal,  depending  upon  whether 
they  are  beyond  or  within  the  control  of  the  bank. 
External  examinations  are  public  or  quasi-pubhc  in 
nature,  since  they  are  made  by  the  national  and  state 
governments  and  also  by  the  clearing  houses.  Internal 
or  private  examinations  are  conducted  by  the  directors 
or  the  stockholders  of  the  bank. 

The  object  of  any  form  of  examination  is  to  deter- 
mine the  solvency  and  liquidity  of  the  institution.  In 
general,  these  factors  are  ascertained  by  an  analysis 
of  the  bank's  assets  in  relation  to  its  liabilities.  In  ex- 
amining assets,  their  actual  existence  must  be  proved 
and  their  true  appraisal  determined.  An  examiner 
must  assure  himself  that  the  assets  as  stated  in  the 
general  ledger  are  really  in  the  possession  of  the  bank 
and  that  it  has  complete  legal  title  to  them.  He  must 
also  compare  the  book  values  of  all  assets  with  their  true 
market  worth  on  the  day  of  the  examination  in  order 
to  discover  any  depreciation.  An  examination  conducted 
by  the  government  must  also  disclose  whether  the  bank 
has  observed  the  laws  relating  to  capital  requirements, 
reserve  computations,  and  loan  restrictions. 

To  attain  these  ends,  the  federal  government  main- 
tains a  staff  of  examiners  under  the  direction  of  the 
Comptroller.  The  examination  division  was  reformed 
after  1907,  when  the  panic  emphasized  the  need  of  more 
efficient  supervision,  and  it  was  further  reorganized 
after  1914,  when  the  Federal  Reserve  Act  revised  the 
banking  system  of  the  country.  The  main  office  is 
located  in  Washington,  and  twelve  branches  correspond- 


REGULATION   OF   BANKING         219 

ing  to  the  Federal  Reserve  districts  are  also  in  opera- 
tion. Each  branch  is  supervised  by  a  chief,  who  directs 
the  work  of  the  field  examiners,  and  the  operation  of 
the  entire  service  is  unified  by  frequent  conferences  of 
the  staff.  Exaininei's  are  requii-ed  to  pass  a  sort  of  civil- 
service  test  to  determine  their  knowledge  of  accounting, 
banking,  and  general  business.  The  law  forbids  an 
examiner  to  derive  any  direct  or  even  indirect  compen- 
sation from  banking  institutions.  He  is  no  longer  com- 
pensated by  a  fee  from  the  bank  which  he  is  examining, 
but  is  now  paid  a  fixed  salary  by  the  government. 

The  cost  of  an  examination  is  carried  by  each  bank 
in  proportion  to  the  amount  of  its  resources  on  the  day 
of  the  investigation.  This  plan  is  more  equitable  than 
to  impose  the  same  assessment  on  all  banks,  for  such 
division  would  prove  burdensome  to  the  smaller  insti- 
tutions. The  law  requires  at  least  two  regular  ex- 
aminations every  year,  and  in  addition  the  Comptroller 
may  order  special  investigations  more  frequently  in 
the  case  of  banks  indicating  an  unsatisfactory  condi- 
tion. The  duration  of  an  examination  may  extend 
from  several  hours  to  several  weeks,  depending  upon 
the  size  of  the  bank.  A  small  bank  can  be  examined 
within  a  day  by  a  single  official,  while  a  large  institution 
requires  the  services  of  several  examiners  and  their 
assistants  for  a  period  of  two  or  more  weeks. 

The  primary  object  of  the  examiner  is  to  verify  the 
actual  existence  of  the  assets  and  liabilities  as  compared 
with  the  entries  in  the  books  of  the  bank.  The 
examiner  starts  his  investigation  by  counting  the 
cash,  for  this  item  can  be  tampered  with,  most  readily 
in  covering  a  defalcation.  Money  in  the  hands  of  the 
various  tellers  is  verified  first,  and  later  the  sums  in 
the  vaults,  for  they  can  be  closed  in  the  meantime  with 
the  examiners'  seals  to  prevent  any  possible  tampering 
with  cash,  secuiities,  or  other  valuables.    The  counting 


220  BANKING   AND   BUSINESS 

of  cash  is  not  difficult,  as  the  legal  reserve  funds  are 
now  maintained  with  the  Federal  Reserve  bank,  and 
the  individual  bank  keeps  relatively  small  sums  in  its 
own  vaults.  Even  this  money  is  not  examined  com- 
pletely, for  packages  containing  small  denominations 
are  checked  merely  in  bulk,  and  only  bills  of  large 
amounts  are  counted  individually.  Coin  may  be  tested 
by  weight  in  bags  or,  if  necessary,  by  actual  count. 

Checks  and  other  items  which  are  to  be  forwarded 
for  collection  and  payment  may  be  verified  by  com- 
municating with  the  banks  on  which  these  instruments 
are  drawn.  In  the  case  of  checks  payable  through  the 
local  clearing  house,  verification  can  be  accomplished 
merely  by  inserting  in  the  batch  of  checks  on  each 
bank  a  shp  requesting  that  the  total  amount  be  verified 
to  the  examiner.  In  the  same  way  the  item  "due  from 
other  banks"  is  reconciled  by  requesting  from  each  of 
these  correspondents  a  statement  of  the  amount  due 
to  the  bank  on  the  day  it  is  being  examined. 

Similarly  the  amount  of  loans  and  discounts  may  be 
ascertained  by  selecting  a  number  of  borrowers  at 
random,  sending  them  a  statement  of  then  obhgations 
and  asking  for  a  confirmation  of  the  amount. 

It  is  highly  important  to  know  what  persons  are 
receiving  loans  from  the  bank.  Are  directors  granting 
such  accommodations  to  themselves?  Are  the  officers 
securing  credit  from  the  bank?  Is  any  one  individual 
or  corporation  obtaining  loans  in  excess  of  the  limits 
prescribed  by  law?  Large  extensions  of  credit, 
although  not  excessive  legally,  are  noted  by  the  exam- 
iner on  special  sheets  which  indicate  the  direct  habihty 
of  any  borrower  as  the  maker  of  notes,  and  show  his 
contingent  obhgation  as  the  indorser  of  some  other 
person's  paper.  These  hability  records  ai'e  filed  in  the 
offi.ce  of  the  government  examination  department.  At 
the  next  examination  of  the  bank,  similar  data  are 


REGULATION   OF   BANKING         221 

secured,  and  if  these  relatively  hea\y  lines  of  credit 
show  no  reduction,  the  facts  are  brought  to  the  atten- 
tion of  the  officers  and  directors,  who  are  then  called 
upon  to  remedy  the  situation. 

The  examiner  also  inspects  the  collateral  which  bor- 
rowers have  pledged  wdth  the  bank.  This  security 
should  possess  a  satisfactory  margin  or  excess  value 
over  the  amount  of  each  loan.  Also  the  collateral 
should  be  readily  marketable,  so  that  the  bank  may 
recover  the  amount  of  its  loans  if  the  borrower  should 
default  in  his  payment.  Advances  based  on  real- 
estate  mortgages  especially  are  observed,  as  such  col- 
lateral possesses  only  a  limited  market.  An  examiner 
also  notes  the  maturity  of  the  bank's  paper  and  analyzes 
obligations  which  have  been  continually  renewed  or 
are  long  overdue.  These  he  lists  as  slow,  doubtful,  or 
estimated  losses. 

In  examining  bonds  and  securities  held  by  the  bank 
as  investments,  their  book  value  is  compared  with 
market  quotations,  and  any  discrepancy  due  to  appre- 
ciation or  depreciation  is  noted  in  the  report.  An 
appraisal  is  also  made  of  fixed  assets,  such  as  the  bank 
building,  furniture,  fixtures,  and  real  estate. 

The  underl}4ng  problem  in  examining  assets  is  to  dis- 
cover any  tendency  toward  o\'er\-aluation.  In  scruti- 
nizing liabilities  of  a  bank  the  examiner  must  be  watch- 
ful for  any  inclination  to  underetate  the  extent  of  these 
obligations.  A  bank,  as  any  other  corporation,  is  ex- 
posed to  the  possible  e\'il  of  an  overissue  of  stock.  An 
attempt  to  sell  more  shares  than  are  authorized  by  the 
charter  can  easily  be  discovered  by  comparing  the 
amount  issued,  canceled,  and  still  outstanding,  as 
entered  in  the  stock-certificate  book  of  the  bank  or  in 
the  records  of  the  registrar  of  the  stock. 

Any  misstatement  of  the  liabilities  due  depositors 
can  be  ascertained  by  communicating  with  them  di- 


222  BANKING  AND   BUSINESS 

rectly.  The  amount  due  to  banks  as  depositors  is  veri- 
fied by  the  same  method  used  in  checking  the  amount 
due  from  other  banks — i.e.,  by  asking  for  a  statement  of 
these  balances.  This  means  cannot  be  apphed  very 
well  to  the  accounts  of  individual  depositors,  who 
might  receive  the  impression  that  the  solvency  of  the 
bank  was  being  questioned.  So  instead,  the  examiner 
may  test  the  accounts  as  entered  in  the  individual 
ledger  by  comparing  them  with  any  pass  books  which 
depositors  have  left  with  the  bank  for  balancing. 

Having  checked  all  assets  and  liabilities,  the  ex- 
aminer enters  these  accounts  in  his  report  of  condition. 
Later  this  report  is  compared  with  the  statement  sub- 
mitted by  the  bank  itself,  and  if  discrepancies  arise 
they  must  be  adjusted.  The  bank  may  be  required  to 
charge  off  losses  on  its  loans  or  depreciation  in  its 
investments.  These  deductions  may  be  large  enough 
to  impair  the  bank's  capital,  and  in  this  event  the 
stockholders  may  be  called  upon  to  make  good  the 
impairment. 

After  an  examination  of  a  bank  has  been  completed, 
the  results  should  be  coixiniunicated  to  the  directors 
to  give  them  an  opportunity  of  correcting  any  irregu- 
larities discovered  in  the  operation  of  the  institution. 
For  this  reason  the  Comptroller  of  the  Currency  fur- 
nishes the  board  of  directors  with  a  copy  of  the  report 
filed  by  the  examiners.  In  some  states  these  findings 
are  brought  to  the  attention  of  the  directors  immedi- 
ately by  giving  the  examiner  power  to  call  a  meeting 
of  the  board. 

Officials  of  the  state  governments  conduct  examina- 
tions of  banks  in  about  the  same  manner  as  the  federal 
examiners.  The  accuracy  and  thoroughness  of  these 
investigations  have  varied  according  to  the  economic 
development  of  the  state.  A  dual  system  of  bank 
examinations  by  both  national  and  state  governments 


REGULATION   OF  BANKING         223 

existed  when  the  Federal  Reserve  Act  was  passed. 
This  statute  provides  for  a  thii-d  form  of  banking 
examination,  as  the  Federal  Reserve  banks  can  exam- 
ine any  of  their  members  and  submit  a  report  of  their 
findings  to  the  board.  Under  such  conditions,  state 
banks  joining  the  Federal  Reserve  system  faced  the 
possibility  of  undergoing  two  sets  of  government  exam- 
inations, and  thus  many  were  at  first  deterred  from  ac- 
cepting membership.  This  disabihty  has  to  a  large  ex- 
tent been  removed,  for  the  Federal  Reserve  Board  may 
accept  the  reports  of  the  state  banking  departments 
in  lieu  of  its  own  examinations.  This  pohcy  has  been 
followed  in  states  which  conduct  efficient  examinations, 
while  in  a  few  Federal  Reserve  districts  it  has  been 
found  necessary  to  conduct  independent  investigations 
of  the  member  banks  incorporated  under  the  laws  of 
some  states.  Assuming  that  the  examination  of  the 
bank  has  disclosed  irregular  practices,  the  national 
Comptroller  or  the  State  Superintendent  has  certain 
means  in  their  power  of  remedying  the  situation.  Warn- 
ings can  be  issued  to  the  dehnquent  bank,  but  its  doors 
can  be  closed  only  when  it  commits  certain  acts  which 
are  legally  regarded  as  indicating  a  state  of  insolvency. 

V.  Clearing-house  Examinations. 

The  work  of  the  government  in  examining  banks  is 
sometimes  supplemented  by  the  co-operation  of  the 
clearing  houses.  Since  the  members  of  these  associa- 
tions are  daily  receiving  obligations  due  from  one 
another,  they  all  have  a  common  interest  in  knowing 
the  true  condition  of  their  associates.  This  thought 
was  deeply  impressed  upon  Chicago  banks  in  190G 
when  several  local  institutions  failed,  and  a  consequent 
panic  was  averted  only  through  the  effoi'ts  of  the  other 
members  of  the  clearing  house  in  sustaming  the  losses 


224  BANKING  AND  BUSINESS 

themselves.  Subsequent  investigations  showed  that 
the  failures  were  the  result  of  irregular  practices  which 
had  escaped  the  notice  of  government  examiners.  To 
prevent  a  recurrence  of  this  condition  the  Chicago 
Clearing  House  Association  introduced  its  own  sj^stem 
of  examining  member  banks.  Similar  action  was  taken 
by  the  clearing  houses  of  other  large  cities  throughout 
the  country,  and  in  sections  where  no  clearing-house 
associations  are  organized,  banks  of  several  cities  have 
combined  into  a  group  system  for  retaining  jointly 
the  services  of  examiners  to  analyze  the  condition  of 
members. 

The  expenses  incurred  in  undertaking  these  examina- 
tions are  defrayed  in  various  ways.  The  method  of 
the  Comptroller  may  be  followed  by  levjdng  an  assess- 
ment upon  each  member  bank  in  proportion  to  its 
total  resources.  This  charge  may  also  be  prorated 
according  to  the  total  clearings  of  each  bank  through- 
out the  year.  A  third  plan  is  to  impose  the  same  fee 
upon  all  banks  irrespective  of  the  amount  of  their 
resources  or  clearings. 

An  examination  by  a  clearing  house  is  thus  inde- 
pendent of  those  undertaken  by  the  government,  and 
also  by  the  individual  banks.  The  investigation  may 
be  conducted  by  the  clearing-house  manager  himself 
or  he  may  delegate  this  task  to  a  special  examiner,  and 
in  a  large  city  this  service  may  be  performed  by  a  firm 
of  accountants.  These  examinations  are  directed  by  a 
special  committee  of  the  clearing  house.  Acting  on 
orders  of  this  body,  the  examiner  may  enter  any  bank 
without  giving  it  pre\dous  notice.  He  analyzes  its 
condition  and  presents  his  findings  in  two  separate  re- 
ports. A  complete  statement  is  forwarded  to  the  du-ec- 
tors  of  the  bank  under  examination.  If  its  condition  is 
satisfactory  a  brief  report  is  submitted  to  the  clearing- 
house committee,  but  this  body  is  given  a  detailed 


REGULATION  OF  BANKING        225 

survey  of  the  bank's  status  if  in  any  way  it  endangers 
the  interests  of  the  other  members.  The  plan  of 
clearing-house  exaiTiination  has  been  criticized  on  the 
ground  that  it  may  disclose  to  competitors  of  the  bank 
confidential  information  regarding  its  credits  and  loans. 
On  the  other  hand,  the  system  of  clearing-house  ex- 
amination is  free  from  some  of  the  restrictions  which 
limit  the  work  of  government  agencies.  In  the  first 
place,  the  examiner,  acting  in  behalf  of  the  clearing 
house,  does  not  confine  his  analysis  merely  to  violations 
of  the  law,  but  may  also  take  into  consideration  prac- 
tices which  may  be  legal,  but  nevertheless  dangerous 
to  the  welfare  of  the  banking  community.  Nor  is  the 
clearing-house  association  compelled  to  wait  until  the 
bank  is  driven  into  insolvency,  but  instead  this  status 
may  be  averted  by  the  prompt  application  of  remedial 
measures. 

VI.  Internal  Examinations. 

In  addition  to  these  external  examinations  conducted 
by  the  government  and  by  the  clearing  house,  an  inter- 
nal investigation  of  the  bank's  condition  is  also  made 
by  the  board  of  directors.  As  a  rule  this  function  is 
delegated  to  a  committee,  which  thus  acquires  an  inti- 
mate knowledge  of  the  bank's  operations. 

VII.  Bank  Audits. 

Another  form  of  internal  analysis  is  the  bank  audit, 
which  differs  from  an  examination,  especially  in  pur- 
pose. It  has  been  shown  that  the  examination  of  a 
bank  seeks  to  verify  the  existence  and  value  of  assets 
and  liabilities  at  a  fixed  date  as  compared  with  the  cor- 
responding entries  in  the  bank's  ledgers.  The  audit 
proceeds  a  step  farther  in  checking  the  records  them- 


226  BANKING  AND  BUSINESS 

selves.  Besides,  an  audit  is  made  not  alone  to  deter- 
mine the  accuracy  of  the  accounts,  but  also  to  test  the 
efficiency  of  the  methods  used  in  keeping  these  records. 
Audits  should  result  in  the  installation  of  systems  which 
possess  a  minimum  of  error  and  a  maximum  of  economy. 
The  records  of  the  bank  may  be  audited  by  a  firm  of 
public  accountants  employed  by  the  board  of  directors. 
Audits  may  also  be  made  by  members  of  the  bank's 
staff.  In  a  small  bank  this  task  quite  naturally  devolves 
upon  the  cashier,  but  another  way  is  to  rotate  the 
clerks  from  one  department  to  another  so  that  they 
will  verify  records  which  they  do  not  handle  in  the 
com'se  of  their  daily  work.  A  large  bank  maintains  an 
auditing  department,  in  order  that  the  more  important 
transactions  can  be  placed  under  constant  observation. 
According  to  the  frequency  with  which  audits  are 
made,  they  may  be  classed  as  either  periodic  or  con- 
tinuous. The  former  are  made  only  at  various  inter- 
vals throughout  the  year,  especially  in  the  case  of  a 
small  bank,  while  a  continuous  audit  is  essential  in 
departments  of  a  large  bank  handling  the  shipment  of 
cash  and  secmities. 

VIII.  Reserve  Requirements. 

The  most  important  obligation  w^hich  a  bank  assumes 
is  the  necessity  of  meeting  its  current  liabilities,  whether 
deposits  or  circulating  notes.  It  is  therefore  essential 
for  the  bank  to  keep  its  general  assets  in  liquid  condi- 
tion, and  particularly  to  maintain  a  portion  of  its 
resources  available  at  all  times  to  meet  these  demand 
obligations.  These  special  assets  are  known  as  the 
reserve.  The  nature  of  this  reserve  and  the  policies 
which  a  bank  may  follow  in  order  to  restore  any  deple- 
tion have  been  discussed  in  Chapter  X;  and  an  expla- 
nation of  the  redemption  of  bank  notes  will  be  deferred 


REGULATION   OF  BANKING         227 

until  Chapter  XXIII.  For  the  present,  consideration 
will  be  given  only  to  the  methods  by  which  public 
regulation  seeks  to  enforce  the  upkeep  of  adequate 
reserves  against  deposit  liabilities. 

To  attain  this  end  the  government  insists  that  banks 
observe  certain  reserve  requirements  which  are  ex- 
pressed as  a  percentage  ratio  between  the  amount  of 
the  bank's  cash  and  available  credit  and  the  total  of  its 
deposits.  How  large  a  reserve  will  be  needed  to  meet 
these  liabihties  depends  to  a  considerable  degree  on  the 
locality  of  the  bank.  If  it  is  situated  in  a  large  money 
center  where  business  men  are  continually  drawing 
checks  against  their  balances,  obviously  a  higher  ratio 
of  reserves  against  deposits  is  necessary  than  in  the 
case  of  a  bank  in  a  smaller  city  where  accounts  are 
less  active. 

The  National  Bank  Act,  therefore,  divided  the 
United  States  into  three  groups:  (1)  central  reserve, 
(2)  reserve,  (3)  nonreserve,  or  country  districts.  The 
first  group  includes  New  York  City,  Chicago,  and 
St.  Louis;  the  second  covers  about  one  hundred  of 
the  larger  cities;  and  the  third,  the  remainder  of  the 
country.  Location  was  the  only  distinction  which  the 
National  Bank  Act  drew  in  fixing  the  amount  of  the 
reserves.  The  Federal  Reserve  Act  continued  the  above 
classification,  but  further  graded  these  requirements 
by  permitting  banks  to  carry  a  lower  reserve  against 
time  than  against  demand  deposits.  The  division 
between  these  two  classes  of  deposits  has  been  arbi- 
trarily set  at  thirty  days,  and  all  accounts  which  can 
be  withdrawn  within  this  period  are  regarded  as  demand 
deposits,  while  time  deposits  include  those  payable  after 
thirty  days. 

Certificates  of  deposits,  savings  accounts  payal)le 
after  thirty  days'  notice,  and  postal  savings  are  re- 
garded as  time  deposits  under  the  Federal  Reserve  .Act. 


228 


BANKING  AND  BUSINESS 


As  soon  as  a  certificate  of  deposit  attains  a  maturity 
of  less  than  thirty  days,  or  as  soon  as  the  holder  of  a 
savings  account  has  notified  the  bank  of  his  intention 
to  withdraw  his  balance,  these  items  then  become 
demand  deposits. 

Based  on  the  principle  of  the  location  of  banks  and 
the  maturity  of  deposits,  the  Federal  Reserve  Act 
as  amended  in  1917  fixes  the  reserve  requirements  of 
member  banks  as  indicated  in  the  following  table: 


Classes  of  Banks 

Demand 
Deposits 

Time 
Deposits 

Central  reserve  city  banks 

Per  Cent 

13 
10 

7 

Per  Cent 

3 

Reserve  city  banks 

Nonreserve  city,  or  country,  banks .  .  . 

3 
3 

Against  demand  deposits,  banks  in  the  central 
reserve  cities  must  maintain  a  reserve  of  13  per  cent; 
in  reserve  cities,  10  per  cent;  and  in  the  remainder  of 
the  country,  7  per  cent.  No  such  distinction  is  drawn 
in  computing  the  reserve  against  time  deposits,  of 
which  only  3  per  cent  need  be  maintained  by  all  banks, 
irrespective  of  their  location. 

The  Federal  Reserve  Act  effected  two  important 
changes  in  the  system  of  reserves  established  by  the 
National  Bank  Act.  In  the  first  place,  the  percentages 
of  reserve  requirements  were  considerably  reduced. 
The  National  Bank  Act  permitted  banks  to  carry  a 
certain  part  of  their  reserves  with  other  institutions, 
but  the  Federal  Reserve  Act  as  later  amended  com- 
pelled the  transfer  of  all  reserves  to  the  Federal 
Reserve  banks.  All  members  of  the  Federal  Reserve 
system,  whether  national  or  state  institutions,  must 
comply  with  the  reserve  requirements  stated  in  the 
above  table. 


REGULATION   OF   BANKING         229 

IX.  Computation  of  Reserves. 

For  the  purpose  of  computing  these  amounts  the 
Federal  Reserve  Board  has  prepared  a  form  to  be 
followed  by  all  member  banks  in  reckoning  reserves. 
In  order  to  illustrate  the  method  of  calculation,  the  form 
as  filled  out  by  a  member  bank  is  presented  below : 

Net  Demand  Deposits: 

1.  Deposits  payable  within  thirty 
days,  not  including 

(a)  U.  S.  Government  deposits 

(b)  Certified  checks  outstand- 
ing 

(c)  Cashier's  checks  outstand- 
ing   $190,434 

2.  Balance  due  to  banks  other 

than  Federal  Reserv^e  banks.  .    SI  11,028 

3.  Cashier's  checks  outstanding.        14,425 

4.  Certified  checks  outstanding. .        14,199 

Total $139,652 

Less: 

Deductions  of  the  following 
items  are  permitted  only  from 
the  total  of  items  2,  3,  and  4. 
Should  the  total  of  items  5,  6, 
7,  and  8  exceed  the  total  of 
items  2,  3,  and  4,  both  groups 
must  be  omitted  from  the  cal- 
culation. 

5.  Balances  due  from  banks  other 

than  Federal  Reserve  banks. .        S9,675 

6.  Items  with   Federal  Reserve 

bank  in  process  of  collection . .  4,369 

7.  Exchanges  for  clearing  house .        50,573 

8.  Checks  on  other  banks  in  the 

same  place 875 

Total  deduction  (items  5,  G, 

7,  and  8) 65,492 

9.  Net  balance  due  to  banks.  ...  74,160 
10.  Total    net    demand    deposits 

(items  1  and  9) $264,594 


230  BANKING  AND   BUSINESS 

Time  Deposits: 

11.  Savings  uccouuts  (subject  to 
not  less  than  thirty  days'  no- 
tice before  payment) $3,542 

12.  Certificates  of  deposit  (sub- 
ject to  not  less  than  thirty 

days'  notice  before  payment)  2,050 

13.  Other  deposits  payable  only 

after  thirty  days 737 

14.  Postal  savings  deposits 3,381 

15.  Total  time  deposits  (items  11,  

12,  13,  and  14) $9,710 

In  the  above  statement  a  separate  computation  is 
made  for  demand  and  for  time  deposits.  As  the 
Federal  Reserve  Act  does  not  require  the  keeping  of 
reserves  against  government  deposits,  only  the  bal- 
ances of  individuals  and  of  banks  are  considered.  The 
Federal  Reserve  Act  does  not  insist  upon  the  main- 
tenance of  reserves  against  gross  bank  deposits,  but 
merely  upon  the  net  difference  between  the  amount 
due  to  other  banks  and  the  amount  due  from  them. 
Thus  for  reserve  purposes,  net  demand  deposits  include 
only  accounts  due  to  individuals  and  net  balances  due 
to  banks. 

Item  1  represents  individual  demand  deposits.  This 
sum  does  not  include  United  States  government 
deposits,  for  these  require  no  legal  reserves.  Checks 
which  have  been  certified  by  the  bank  or  drawn  by  its 
cashier  are  carried  as  separate  entries,  and  items  2, 
3,  4  together  constitute  the  total  sums  due  to  other 
banks.  These  three  accounts  represent  the  gross 
habihties  due  to  other  banks,  and  from  the  sum  a  de- 
duction of  the  assets  due  from  other  banks  must  be 
allowed.  These  accounts  arise  either  from  balances 
carried  with  correspondents  or  from  items  being  col- 
lected by  the  Federal  Reserve  Bank,  the  clearing  house, 
or  the  bank's  messengers.  These  amounts  are  indicated 


REGULATION   OF  BANKING         231 

by  items  5,  6,  7,  and  8,  which  together  represent  the 
amount  due  from  other  banks.  The  difference  be- 
tween the  total  of  items  2,  3,  and  4,  the  amount 
due  to  other  banks,  and  the  total  of  items  5,  6,  7, 
and  8,  the  aggregate  due  from  other  banks,  is  in- 
dicated by  item  9,  wliich  is  the  net  balance  due  to 
other  banks. 

A  bank  does  not  always  owe  to  other  banks  an 
amount  larger  than  that  of  their  indebtedness  to  it,  and 
at  times  the  sum  of  interbank  credits  more  than  offsets 
the  total  debits.  From  this  situation  the  bank  derives 
no  advantage,  for  under  the  Federal  Reserve  plan  when 
the  total  due  from  banks  exceeds  the  amount  due  to 
banks,  both  groups  of  items  must  be  entirely  omitted 
from  the  calculation  of  reserves.  In  this  case  the  bank 
carries  a  reserve  only  against  item  1,  its  individual 
deposits.  If  there  is  a  net  balance  due  to  other  banks 
as  shown  in  item  9,  it  is  added  to  item  1,  and  these  two 
accounts  together  form  the  total  net  demand  deposits. 

Less  difficulty  is  encountered  in  calculating  time 
deposits,  which  include  the  following  items:  (11)  Sav- 
ings accounts,  (12)  certificates  of  deposit,  (13)  other 
deposits  payable  only  after  thirty  days,  and  (14)  postal 
savings  deposits.  As  mentioned  above,  a  tune  deposit 
is  any  account  which  is  payable  only  after  a  notice  of 
thirty  days. 

In  the  illustration  under  consideration  the  net  de- 
mand deposits  amount  to  $264,594,  and  time  deposits 
to  S9,710.  Assuming  that  this  bank  is  located  in  the 
nom'eserve  class,  it  is  required  to  hold  as  reserve  7  per 
cent  of  its  demand  deposits  and  3  per  cent  of  its  time 
deposits.  Its  reserve  against  demand  deposits  will  thus 
amount  to  $18,521.58,  against  time  deposits,  S291.30, 
and  these  two  sums  together  $18,812.88.  Although 
reserves  must  be  computed  every  day,  the  bank's  re- 
quired amount  is  counted  not  as  a  daily,  but  as  an 

16 


232 


BANKING  ANH  BUSINESS 


average,  monthly  balance,  and  a  deficit  on  one  day 
may  be  offset  by  a  surplus  at  another  time. 


X.  Liquidation  of  Banks. 

Notwithstanding  the  above  regulations  of  the 
government,  banks  at  times  become  insolvent.  It  is  in- 
teresting to  note  the  principal  causes  of  failures  among 
national  banks  since  the  inauguration  of  the  national 
banking  system,  as  indicated  in  the  report  of  the  Comp- 
troller of  the  Currency  for  1920  (Vol.  I,  p.  183). 


Number  of 
Banks 

Percentage  of 
Failures 

1.  Involving  criminal  action. .  .  . 

228 

114 
83 

12 

139 

9 

9 

38.4 

Defalcation  of  officers 

Fradulent  management 

Wrecked  by  cashier 

Wrecked   by   defalcation    of 
bookkeeper  

51 

128 

46 

1 
2 

Wrecked  by  asst.  cashier .... 
2.  Involving  unlawful  acts 

19.2 

Excessive  loans  to  officers . . . 

Excessive  loans  to  others  .  .  . 

3.  Depreciation  of  assets 

62 
52 

14.0 

Securities 

19 
14 
50 

Real  estate 

General  stringency 

4.  Failure  of  large  debtors 

2.0 

5.  Injudicious  banking 

23.4 

6.  Closed  by  run  or  in  anticipation 

7.  No  record  of  cause 

1.5 
1.5 

Total 

594 

100.0 

The  public  supervisors  of  banks  have  only  limited 
power  in  closing  banks  which  are  headed  for  insolvency. 
The  federal  Comptroller  or  the  State  Superintendent 
can  take  action  against  a  bank  only  if  it  commits  a 


REGULATION   OF  BANKING         233 

clear  violation  of  the  law.  If  a  bank  arbitrarily  exceeds 
the  powers  authorized  by  its  charter,  if  it  continually 
fails  to  maintain  its  reserve,  or  when  it  willfully  impairs 
its  capital,  such  offenses  may  lead  to  its  ultimate  dis- 
solution. For  these  contingencies  the  national  and 
state  laws  have  given  their  supervisory  officials  powers 
of  varying  scope.  In  some  states  the  Superintend- 
ent of  Banks  must  apply  to  the  courts  for  the  appoint- 
ment of  a  receiver.  Until  the  appUcation  is  granted 
valuable  time  may  be  lost  and  the  condition  of  the 
offending  bank  may  become  increasingly  unsatisfac- 
tory. In  other  states,  laws  empower  the  Superintend- 
ent to  take  inomediate  possession  of  the  baiik's  affairs. 
This  official  then  requests  a  court  to  nominate  a  re- 
ceiver, who  takes  charge  of  the  assets  and  liabilities  of 
the  bank.  The  National  Bank  Act  not  only  permits 
the  Comptroller  of  the  Currency  to  assume  immediate 
charge  over  the  affairs  of  the  bank,  but  also  allows  him 
to  appoint  the  receiver. 


CHAPTER  XV 

INTERBANK  RELATIONS 

What  has  thus  far  been  said  about  banking  deals 
chiefly  with  relations  between  the  bank  and  the  indi- 
vidual or  between  the  bank  and  the  pubhc.  It  must  be 
remembered,  however,  that  in  most  countries  there  are 
many  banks.  In  some,  where  branch  banking  is  fol- 
lowed, these  banks  are  not  independent  of  one  another 
in  the  sense  of  having  a  different  corporate  existence, 
but  they  are  different  offices  of  the  same  institution. 
In  others,  however,  they  are  separately  organized  and 
are  in  other  respects  independent  banks.  In  the  United 
States  we  have  about  30,000  independently  organized 
banks,  each  with  its  own  charter.  Of  these  banks 
about  8,000  have  been  chartered  by  the  federal  govern- 
ment, while  others  have  been  chartered  by  the  state 
governments.  In  foreign  countries  the  number  of 
independent  banks  is  usually  very  much  smaller,  but 
these  banks  are  authorized  to  estabhsh  branches.  Thus 
in  Canada  at  the  present  time,  for  example,  the  number 
of  banks  is  17,  but  the  various  banks  are  authorized  to 
establish  branch  offices.  It  is  probable  that  in  Canada 
there  is  an  even  larger  number  of  bank  offices  open  to 
the  public  than  in  the  United  States  in  proportion  to 
population,  the  total  number  of  branches  there  being 
4,676.  Exactly  how  many  independent  banks  or 
branch -bank  offices  there  should  be  in  a  country 
depends  upon  circumstances.  There  is  no  definite 
rule    in    the    matter.     Conditions    of   transportation 


INTERBANK   RELATIONS  235 

and  volume  of  business  available  in  various  com- 
munities determine  the  number  of  offices  thus  to  be 
established. 

Whether  the  banks  are  independently  organized  or 
are  simply  different  offices  of  the  same  general  organiza- 
tion, it  still  remains  true  that  they  must  have  various 
relationships  with  one  another.  Not  all  persons  do 
business  with  the  same  bank,  and  consequently  every 
bank  obtains  claims  upon  other  banks  or  has  to  pay 
claims  held  by  others.  Thus  it  becomes  essential  to 
develop  a  definite  system  of  deaUngs  between  banks. 
These  dealings  maj'-  be  classified  in  a  general  way  as 
collection  and  remittance,  deposit,  and  rediscount. 
There  are  other  functions  which  are  performed  by 
banks  for  other  banks,  but  they  are  of  the  same  general 
description  that  may  be  performed  by  any  business 
house  for  another.  Those  that  have  just  been  men- 
tioned are  distinctly  banking  functions,  and  as  such 
they  require  a  particular  kind  of  banking  organization 
in  order  that  they  may  be  successfully  carried  on. 

I.  Interbank  Relationships. 

1.  Collection. 

The  simplest  type  of  interbank  relationship  is  that  of 
collection.  Bank  A  receives  from  a  depositor  a  check 
on  bank  B.  It  credits  this  check  to  the  depositor — 
that  is  to  say,  it  undertakes  to  pay  him  the  face  of  the 
check  on  demand.  This  necessitates  action  on  its  o^^Tl 
part  for  the  purpose  of  collecting  the  check  from  the 
bank  on  which  it  is  drawn.  It  might  send  the  check 
to  the  other  bank  and  ask  for  cash,  the  messenger 
turning  in  the  check  over  the  counter,  getting  the 
money,  and  bringing  it  back  with  him.  Sometimes  this 
plan  is  still  emploj'cd,  but  it  is  a  prunitive  and  unsatis- 
factory way  of  doing  business.     The  second  method  is 


236  BANKING  AND   BUSINESS 

that  of  accumulating  checks  on  other  banks  and 
eventually  offsetting  them  against  checks  accumulated 
in  the  same  way  by  other  banks  against  it.  This  is 
called  ''clearing."  A  third  method  of  disposing  of  the 
check  is  that  of  depositing  it  with  some  other  bank — 
perhaps  the  one  on  which  it  is  drawn — which  thereupon 
gives  credit  for  it.  In  this  case  the  bank  receiving  the 
check  is  said  to  be  a  depository  and  the  two  banks  are 
termed  correspondents. 

2.  Clearing. 

The  most  familiar  tjrpe  of  relationship  between  banks 
is  that  of  clearing,  and  for  purposes  of  convenience  it  is 
customary  that  banks  should  be  united  in  what  is  called 
a  clearing  house.  A  clearing  house  is  usually  an  un- 
incorporated local  association  of  banks  formed  for  the 
purpose  of  conducting  interbank  relationships.  There 
are  clearing  houses  in  all  of  the  principal  financial  cen- 
ters of  the  world,  and  in  the  United  States  there  are 
upward  of  200  such  organizations.  Some  of  them  are 
very  small  and  their  business  is  conducted  upon  an 
extremely  simple  and  elementary  basis.  Others  are 
highly  organized  and  have  their  own  buildings  and 
elaborate  organization.  Some  have  in  years  past 
undertaken  the  task  of  examining  their  members  and 
of  reporting  to  a  clearing-house  committee  whenever 
bad  financial  practices  showed  themselves.  Still  others 
have  in  various  ways  performed  mutual  service  for  the 
banking  community.  In  all,  however,  the  central 
function  of  the  clearing  house  has  been  that  of  offsetting 
claims  against  one  another.  The  t^echnic  of  clearing 
has  been  fully  treated  in  manj'-  authoritative  w^orks  on 
the  subject.  Only  the  underljdng  thought  or  idea  of 
the  process  mil  be  referred  to  here.  Suppose  the 
existence  of  only  two  banks  which  have  constituted 
themselves  a  clearing  house.     Bank  A  has  in  the  course 


INTERBANK   RELATIONS  237 

of  its  business  received  checks  drawn  on  bank  B  in  the 
amount  of  $10,000.  Bank  B  has  received  a  like 
amount  in  checks  drawn  upon  A.  Of  course,  in  receiv- 
ing these  checks  each  bank  has  credited  them  to  the 
depositors.  A's  books  therefore  show  a  UabiUty  of 
$10,000  to  depositors,  while  on  the  asset  side  it  has 
accumulated  an  item  called  "exchanges  for  clearing 
house,"  which  consists  of  the  total  of  checks  on  other 
banks  thus  deposited.  A  like  situation  exists  in  bank 
B.  Representatives  of  the  two  banks  now  meet  and 
each  hands  the  other  the  bundle  of  checks  drawn  upon 
it.  Bank  A  has  thus  eliminated  its  "exchanges  for 
clearing  house"  from  its  assets.  In  return  it  has 
received  a  bundle  of  checks  drawn  upon  it  by  its  own 
depositors.  It  now  charges  these  checks  to  the  ac- 
count of  the  depositors  who  originally  drew  them.  The 
same  step  is  taken  by  bank  B.  Now  the  situation  is 
the  same  as  it  would  have  been  if  the  checks  had  in  the 
first  place  been  directly  deposited  in  the  banks  upon 
which  they  were  drawn.  The  effect  of  the  clearing  has 
been  nothing  more  than  to  offset  the  claims  against 
one  another.  There  is  evidently  no  source  of  income  in 
this  process,  and,  on  the  other  hand,  no  loss.  The 
clearing  house  probably  requires  the  use  of  an  office  or 
room  and  perhaps  a  little  clerical  assistance,  so  that  it 
involves  some  expense  which  may  be  divided  pro  rata 
between  the  two  banks.  At  all  events,  the  clearance 
has  resulted  in  avoiding  payments  of  coin,  and  has  in 
effect  extended  the  bookkeeping  process  of  each  bank 
so  as  to  include  the  checks  whioli  are  not  directly 
deposited  with  it.  It  is  thus  a  labor-saving  device 
and  also  a  great  economizer  of  money. 

If  a  third  bank,  C,  now  enters  the  clearing  group, 
the  process  becomes  somewhat  more  complicated.  A 
presents  bundles  of  checks  to  B  and  C,  B  to  A  and  C, 
and  C  to  B  and  A.     It  is  always  possible  that  there 


238  BANKING  AND   BUSINESS 

will  be  what  is  called  a  perfect  clearance — that  is  to 
say,  that  the  total  amount  which  each  bank  has  against 
the  other  two  is  equal  to  the  aggregate  which  they 
present  to  it.  This,  however,  is  a  rather  unUkely  con- 
tingency. The  chances  are  that  some  one  of  the  three 
banks  will  either  owe  the  others  or  be  a  creditor  of  the 
others,  and  this  remains  true  even  as  the  number  of 
banks  included  is  enlarged.  Now  if  A  owes  C,  let  us 
say,  $500,  while  B  owes  a  like  amount  to  A,  and  C  owes 
$500  to  B,  it  is  evident  that  each  member  owes  $500 
and  is  due  $500.  The  pa^nnents  may  thus  be  allowed 
to  cancel.  If,  on  the  other  hand,  the  debts  are  not 
exactly  equal  in  amount  the  clearing  house  may  direct 
A  to  settle  with  C,  while  B  is  released  from  paying  A, 
and  A  is  released  from  paying  C.  In  this  way  the 
number  of  payments  to  be  made  can  be  reduced. 
Another  way  of  meeting  the  same  situation  is  that  of 
requiring  each  bank  to  keep  a  certain  balance  with  the 
clearing  house.  Then  debtor  banks  draw  checks  in 
favor  of  the  clearing  house,  while  creditor  banks  are 
paid  by  it.  The  result  is  to  settle  the  whole  series  of 
transactions  with  a  minimum  of  actual  pajnnents. 

Another  complicating  element  may  come  into  the 
situation  if  the  clearing  house  permits  its  members  to 
present  checks  drawn  upon  banks  which  are  not  repre- 
sented in  the  clearing  house  but  which  have  requested 
certain  members  to  clear  for  them.  In  such  cases  the 
different  members  may  be  merely  representatives  of  a 
string  of  banks  whose  transactions  pass  through  them, 
and  are  cleared  on  its  books.  Again  the  question  may 
arise  whether  such  clearances  for  nonmembers  are 
made  in  behalf  of  banks  which  are  situated  in  the  same 
city  or  outside  of  it.  There  is  no  reason  why  a  member 
of  the  New  York  clearing  house  should  not  undertake 
to  clear  the  checks  of  a  bank  located  in  San  Francisco 
if  it  wishes  to  do  so,  and  the  question  whether  it  could 


INTERBANK  RELATIONS  239 

afford  to  do  such  work,  and  if  so  at  what  charge,  would 
then  have  to  be  settled  between  the  New  York  clearing 
member  and  the  San  Francisco  bank.  Ordinarily,  how- 
ever, the  checks  for  out-of-town  banks  which  are 
brought  to  the  clearing  house  by  members  are  segre- 
gated and  are  put  through  a  separate  di\'ision  of  the 
organization,  which  is  known  as  the  country  clearing 
house.  Of  this  more  will  be  said  at  a  later  point.  It 
is  enough  to  remark  here  that,  in  general,  clearings  in 
the  proper  sense  of  the  t^rm  are  made  on  an  instanta- 
neous basis — that  is  to  say,  they  represent  items  which 
are  immediately  cashable. 

As  has  already  been  noted,  banks  instead  of  clearing 
their  items  might  simply  deposit  tiiem  with  the  other 
banks  on  which  they  are  drawn,  lea\ing  them  on  deposit 
there.  This,  in  fact,  is  the  way  in  which  many  checks 
are  disposed  of  when  they  are  deposited  with  banks 
which  are  located  elsewhere  than  the  institutions  on 
which  they  are  drawn.  For  example,  bank  A  in  New 
York  City  may  have  received,  say,  $10,000  of  checks 
dra\Mi  upon  banks  in  various  small  towns  in  Cali- 
fornia. At  the  end  of  the  day's  work  these  checks  are 
carefully  sorted  and  massed  together  with  others.  The 
bank  will  then  send  the  whole  §10,000  to  a  correspond- 
ent in  San  Francisco.  This  San  Francisco  bank  will 
give  bank  A  a  credit  for  the  $10,000,  and  it  will  then 
proceed  to  collect  the  checks.  Perhaps  it  may  send 
some  of  them  direct  to  the  banks  on  which  they  were 
drawn.  For  example,  suppose  that  one  of  the  checks 
was  for  $500,  and  was  drawn  on  a  Fresno  bank.  The 
San  Francisco  bank  may  transmit  it  to  the  Fresno 
institution,  or  perhaps  to  another  bank  in  Fresno,  for 
credit.  Or  it  may  happen  that  the  Fresno  bank  has 
an  account  with  the  San  Francisco  hank,  in  which  case 
the  San  Francisco  bank,  having  been  pro\  iously  author- 
ized to  do  so,  charges  the  $500  off  against  the  Fresno 


240  BANKING  AND  BUSINESS 

Imnk's  account  on  its  books.  In  this  case  it  has  simply 
given  credit  to  the  New  York  bank  for  $500  and  reduced 
the  Fresno  bank's  credit  by  $500.  Suppose  now  that 
in  the  course  of  its  regular  business  the  San  Francisco 
bank  receives  a  check  drawn  on  bank  A  in  New  York 
City,  which  originally  sent  it  the  $10,000  for  deposit. 
It  may  charge  this  $500  check  off  against  the  credit 
on  its  own  books  in  favor  of  bank  A,  thereupon  remit- 
ting the  check  as  a  paid  item  to  the  New  York  bank. 
Or  it  may  be  that  in  all  these  cases  the  bank  on  which 
the  check  is  drawn  has  stipulated  that  it  wants  to  see 
and  approve  the  signatures  on  checks  before  they  are 
paid,  and  in  that  case  they  may  simply  be  sent  to  it, 
and  when  found  to  be  correct  the  transmitting  bank 
will  be  directed  to  mark  them  off  against  the  account. 
This  process  is  usually  referred  to  as  collection,  as  dis- 
tinct from  clearing.  The  difference  between  the  two 
is  that,  whereas  clearing  is  an  instantaneous  process  in 
which  only  balances  are  settled,  collection  is  a  con- 
tinuous process  in  which  the  proceeds  of  items  are 
remitted.  It  may  easily  be  that  in  collection  not  a 
single  cent  of  money  is  ever  passed.  Bank  A,  for 
example,  may  in  the  course  of  a  year  send  $1,000,000, 
at  one  time  or  another,  in  checks  to  bank  B  and  get 
credit  for  them,  while  bank  B  may  in  the  course  of  the 
same  time  send  a  like  amount  to  A,  the  two  accounts 
"washing  out"  at  the  end  of  the  period  and  neither 
bank  owing  the  other  anything.  In  such  cases  the 
payments  are  sometimes  said  to  have  been  "cleared 
on  the  books,"  but  the  process  is  not  clearing  because 
it  has  involved  time.  It  is  a  process  of  collection  and 
settlement  by  means  of  credit. 

3.  General  Services 

For  various  reasons  banks  find  it  deskable  to  carry 
balances  with  other  banks.     The  primary  reason  for 


INTERBANK   RELATIONS  241 

such  balances  is  that  of  keeping  themselves  in  position 
to  furnish  their  customers  with  exchange.  X,  for 
instance,  who  is  a  customer  of  bank  B  in  San  Fran- 
cisco, may  find  it  necessary  from  time  to  time  to  pay 
his  debts  in  New  York  funds,  which  means  that  he 
occasionally  wants  a  check  which  is  payable  in  New 
York.  He  obtains  this  by  asking  his  bank  to  draw  in 
his  favor  or  in  favor  of  a  designated  concern  upon  the 
balance  which  it  is  carrying  with  the  New  York  bank. 
This  makes  it  desirable  for  the  country  bank  to  have 
a  sufficient  balance  in  New  York — and  of  course  at 
Other  points  in  case  it  has  to  draw  upon  them.  When 
such  relations  exist  between  banks  one  is  said  to  be 
the  correspondent  of  the  other,  and  such  correspond- 
ents frequently  undertake  various  duties.  These 
duties  may  be  of  a  more  or  less  elaborate  character  or 
they  may  be  comparatively  few  in  number.  The 
country  correspondent  of  a  city  bank  usually  does 
nothing  for  that  bank  except  to  collect  funds,  remit 
them,  and  possibly  carry  a  balance  in  its  favor.  The 
city  correspondent  for  a  country  bank  does  the  same 
kind  of  work,  but  is  ordinarily  called  upon  to  carry 
a  larger  balance  and  to  allow  interest  upon  it.  From 
time  to  time  it  may  be  allowed  to  invest  this  balance 
or  a  part  thereof,  passing  upon  the  securities  or  notes 
that  are  taken  and  thus  morally  guaranteeing  their 
goodness.  Conversely,  it  may  be  asked  to  convert 
such  securities  or  notes  into  cash  through  repurchase 
or  rediscount.  It  may  also  be  asked  to  open  foreign 
credits  on  behalf  of  the  country  bank  and  to  transact 
various  other  kinds  of  business.  The  city  bank  usually 
supplies  its  correspondent  information  from  its  credit 
files,  and  the  latter  may  be  occasionally  requested  by 
the  city  bank  to  supply  information  regarding  some 
individual  or  concern  in  its  own  immediate  neighbor- 
hood as  to  which  the  city  bank  wishes  to  be  informed. 


242  BANKING  AND  BUSINESS 

II.  Interbank  Organization. 

While  considering  the  general  question  of  interbank 
relationships,  it  is  desirable  to  refer  briefly  to  the  idea 
of  bank  federation  or  of  interbank  organization.  What 
has  been  said  thus  far  has  reference  to  a  condition  of 
affairs  in  which  interbank  relationships  have  developed 
simply  as  the  outcome  of  voluntary  action  on  the  part 
of  different  institutions  and  is  the  outgrowth  of  business 
necessity  or  convenience.  A  good  example  of  such 
relationships  is  afforded  by  the  national  banking  sys- 
tem prior  to  1913.  Under  the  old  provisions  of  the 
National  Bank  Act,  banks  might  act  as  correspondents 
for  one  another  practically  as  they  chose,  while  the 
law  provided  for  a  permissive  system  of  ''reserve 
agencies,"  which  meant  that  banks  in  certain  places 
were  allowed  to  hold  balances  for  banks  at  other  points 
and  to  count  them  as  reserves  in  the  legal  sense  of  the 
term.  In  other  cases,  however,  it  has  been  found 
desirable  to  establish  a  more  or  less  compulsory  system 
of  interbank  relationship.  This  may  be  the  outgrowth 
of  commercial  custom,  which,  if  anything,  is  stronger 
than  law,  or  it  may  be  the  outgrow^th  of  actual  legisla- 
tion. Of  the  two  systems  the  British  banking  system 
perhaps  furnishes  the  best  example  in  the  former  case, 
while  the  Federal  Reserve  system  is  the  best  example 
in  the  latter.  The  working  of  the  Federal  Reserve 
system  is  fully  discussed  elsewhere,  but  at  this  point 
it  is  well  to  note  that  the  outstanding  feature  of  the 
system  is  the  establishment  of  legally  required  inter- 
bank relationships  whereby  all  banks  maintain  a  de- 
posit credit  with  a  co-operatively  owned  institution 
known  as  a  Federal  Reserve  bank.  The  purpose  of 
this  system  is  to  insure  the  advantages  which  come 
from  close  interbank  relationships,  and  to  regulate 
or  control  such  relationships  upon  a  definite  plan  under 


INTERBANK   RELATIONS  243 

which  all  have  equal  access  to  the  co-operative  institu- 
tions. The  use  of  the  co-operati\-e  mechanism  is  left 
entirely  to  the  discretion  of  the  members,  who  may  col- 
lect through  it  or  discount  with  it,  as  they  see  fit.  The 
system  simply  enables  them  to  do  these  things  when 
their  necessities  require  or  their  convenience  dictates. 
There  is  nothing  in  the  law  to  prevent  them  from  estab- 
lishing other  interbank  relationshijis  at  present,  and  as  a 
matter  of  fact  most  of  them  maintain  such  relationships. 
It  should  be  noted  also  that  the  problem  of  inter- 
bank relationships  is  rather  different  in  those  countries 
where  branch  banking  exists  from  what  it  is  in  those 
where  banks  are  not  allowed  to  establish  branches. 
Experience  shows  the  desirability  of  a  great  number 
of  banking  offices.  This  is  partly  a  matter  of  con- 
venience. The  easier  the  access  to  the  bank,  the  more 
promptly  will  checks  and  drafts  be  deposited  and  the 
less  danger  will  there  be  of  the  hoarding  of  coin.  It  is 
also,  however,  a  matter  of  easy  extension  of  credit. 
Credit  is  best  studied  at  close  range,  and  not  only  for 
this,  but  for  many  other  reasons,  it  is  admitted  that 
the  tendency  of  banking  offices  is  to  increase  in  number. 
Thus  in  the  United  States  we  have  to-day  about 
30,000  banking  offices  of  all  kinds,  with  perhaps 
110,000,000  of  people.  In  Canada,  with  possibly 
10,000,000  people,  there  are  only  17  banks,  but  the 
number  of  branches  existing  there  brings  the  total  of 
offices  up  to  probably  4500  to  5000.  Where  the 
banking  system  is  organized  with  a  few  head  offices 
and  a  system  of  branches  depending  upon  each, 
interbank  relationships  become  less  important,  and  in 
place  of  them  the  relationship  between  the  parent  bank 
and  its  offices  assumes  broadcM-  significance.  There  is 
still,  of  course,  question  of  the  relations  to  be  main- 
tained between  the  several  heatl  ofiices  and,  to  an 
extent,  between  the  branch  offices  located  at  a  given 


244  BANKING  AND  BUSINESS 

point,  but  the  real  problem  of  interbank  relationship 
is  not  found  there,  but  is  found  in  the  control  exercised 
by  the  parent  over  its  offshoots.  First  of  all  is  the 
question  how  funds  shall  be  apportioned  to  the  dif- 
ferent branch  offices  as  a  basis  for  loans.  Problems 
of  exchange  of  course  present  themselves  just  as  they 
do  between  independent  banks  in  different  parts  of  the 
country.  The  regulation  of  the  seasonal  flow  of  funds 
back  and  forth  between  districts  presents  a  special 
question  for  determination.  Such  questions  are  ad- 
justed through  competition  where  independent  inter- 
bank relationships  are  the  basis  of  the  banking  struc- 
ture, while  under  a  system  like  that  of  the  Federal 
Reserve  they  may  thus  be  said  to  be  adjusted  upon  a 
basis  of  competition  subject  to  supervisory  control  by 
the  co-operative  organization.  Under  a  pure  inde- 
pendent branch  system,  like  that  which  exists  in 
Canada,  the  problem  of  the  head  office  with  respect 
to  the  matters  already  mentioned  is  a  very  broad  one, 
since  it  involves  not  merely  the  question  of  passing 
upon  the  individual  loans  and  credits,  but  also  that  of 
determining  the  distribution  of  accommodation  be- 
tween different  parts  of  the  country.  It  is  because  of 
the  prevailing  belief  that  such  problems  are  likely  to 
be  selfishly  dealt  with  that  there  has  grown  up,  par- 
ticularly in  the  United  States,  a  prejudice  against  the 
branch  banking  system.  This  prejudice  has  been 
strengthened  by  the  contention  that  small  banks  are 
likely  to  be  subject  to  unfair  competition  as  a  result 
of  the  efforts  of  large  competitors  operating  through 
branches  established  at  points  where  there  is  not  suffi- 
cient business  to  maintain  more  than  one  institution. 

III.  Technic  of  Local  Clearing. 

Having  thus  reviewed  the  theory  of  clearing  and 
the  relations  between  correspondent  banks,  it  may  be 


INTERBANK   RELATIONS  245 

worth  while  to  sketch  briefly  the  technic  of  clearing  as 
developed  in  the  United  States  to-day.  It  has  been 
noted  in  an  earlier  part  of  the  chapter  that  there  exist 
in  the  United  States  large  numbers  of  clearing  houses 
situated  at  various  points.  These  clearing  houses  have 
no  relation  with  one  another,  but  they  are  independent 
units.  In  a  general  way  they  are  organized  as  non- 
incorporated  associations,  and  their  function  consists 
of  offsetting  checks  and  drafts  against  one  another, 
arranging  for  mutual  examination  and  generally  exer- 
cising a  common  supervision  over  the  member  banks 
of  the  organization.  The  technic  of  clearing  is  com- 
paratively simple  and  has  been  outlined  in  its  applica- 
tion to  the  city  department  by  Mr.  Jerome  Thralls, 
formerly  secretary  of  the  Clearing  House  Section  of  the 
American  Bankers'  Association,  as  follows: 

Each  member  maintains  in  its  office  a  department  knowTi  as 
its  clearing-house  department,  and  to  which  are  charged  by  the 
several  departments  all  items  dra^\ai  on  or  payable  at  the  offices  of 
the  other  members.  These  items  are  usually  recorded  in  the  de- 
partment where  they  originate  and  on  reaching  the  clearing-house 
department  are  inspected  as  to  signature,  dates,  etc.,  and  are  in- 
dorsed with  a  rubber  stamp,  shoeing  the  name  and  clearing-house 
number  of  the  clearing  bank  and  the  date  of  clearing.  They  are 
next  sorted — all  items  dra\\'n  on  or  payable  at  the  office  of  each 
member  being  placed  in  a  separate  pile.  When  the  sorting  is  com- 
pleted and  the  clearing  hour  approaches,  each  pile  of  checks  is 
taken  to  an  adding  machine  and  a  list  thereof  is  made  and  a  total 
is  taken.  The  items  are  then  done  up  into  packages,  the  list  cover- 
ing each  package  being  placed  on  its  face,  and  the  clearing-house 
numbers  of  the  members  on  which  the  items  are  to  be  cleared  are 
marked  on  the  respective  packages  with  jien  or  jjcncil.  The  lists 
on  the  packages  are  indorsed  with  the  regular  clearing-house  in- 
dorsement stamp.  The  packages  are  then  sealed  or  bound  up  with 
rubber  bands. 

Each  member  is  supplied  by  the  clearing  house  with  statement 
blanks  which  are  in  duplicate  form  and  which  show  at  the  top  the 
name  and  number  of  the  mcml)cr  using  the  same.  The  blanks 
used  in  different  places  are  not  uniform.  .  .  . 


246  BANKING  AND  BUSINESS 

Along  the  left  margin  of  each  statement  appear,  in  regular  order, 
the  names  and  numbers  of  all  the  members.  Immediately  to  the 
right  of  these  names  and  numbers  are  several  columns,  the  two 
principal  ones  of  which  are  headed  "On  Clearing  House"  and 
"  From  Clearing  House."  The  total  shown  on  each  package  of  items 
is  entered  in  the  column  "On  Clearing  House"  and  directly  oppo- 
site the  name  and  number  of  the  bank  on  which  the  items  are  to 
be  cleared.  When  all  totals  have  been  entered,  the  statement  is 
footed,  and  if  the  work  has  been  con-ectly  done  the  footings  thus 
obtained  will  prove  against  the  combined  total  of  all  charges  made 
by  the  several  departments  to  the  clearing-house  department. 
Assuming  they  do  so  prove,  the  packages  are  placed  in  a  satchel 
or  chest  and  the  clearing-house  clerk  and  messenger  take  the 
satchel  or  chest  and  statement  and  make  a  mad  rush  to  the  clearing 
house.  The  reason  for  this  rush  is  that  the  clearing  hour  is  fixed, 
and  any  member  not  represented  on  the  dot  is  fined;  and  if  tardy 
over  a  certain  number  of  minutes  the  member  is  shut  out  of  the 
clearing  for  the  daj^ 

The  exchange  room  at  the  clearing  house  is  equipped  with  a 
cage  or  desk  for  each  member,  and  a  manager's  desk.  The  cages 
are  usually  arranged  in  parallel  rows  and  in  numerical  order  with 
reference  to  the  numbers  of  the  members.  On  arrival  at  the  clearing 
house  the  clerks  enter  their  respective  cages  and  the  messengers 
pass  around  and  deposit  their  packages  of  items — package  No.  1 
being  deposited  in  cage  No.  1,  package  No.  2  in  cage  No.  2,  and  so 
on  dowTi  the  line.  When  all  clerks  and  messengers  have  arrived  at 
the  clearing  house  and  all  deposits  have  been  made,  each  clerk  has 
on  his  desk  a  package  of  items  from  each  member,  and  he  enters 
on  his  statement  in  the  column  headed  "From  Clearing  House" 
and  opposite  the  respective  names  and  numbers  of  the  members 
the  amount  sho^vn  on  the  package  received  from  each.  The  pack- 
ages when  thus  entered  are  dropped  into  a  receptacle,  from  which 
they  are  taken  bj''  the  messengers,  who  rush  back  to  the  banks  so 
that  the  items  may  be  quickly  distributed  to  the  bookkeepers,  who 
pass  upon  the  genuineness  of  signatures,  etc.,  all  items  being  cleared 
subject  to  being  returned  at  a  certain  hour  if  found  not  good  for 
any  reason.  Each  clerk  foots  his  statement  when  all  totals  ha\c 
been  entered,  and  if  he  finds  he  brought  a  greater  volume  to  the 
clearing  house  than  he  received  from  the  members  he  carries  his 
"From  Clearing  House"  footings  to  his  "On  Clearing  House" 
column  and  makes  his  deductions,  sho^ving  the  amount  due  his  bank 
from  the  clearing  house,  or  his  credit  balance,  as  it  is  termed.  Should 
the  amount  received  at  the  clearing  house  exceed  the  amount 


INTERBANK   RELATIONS  247 

brought  to  llie  clearing  house,  the  operation  would  be  the  reverse, 
and  he  would  show  the  amount  due  the  clearing  house,  or  his  debit 
balance.  A  duplicate  of  each  statement  is  passed  to  the  manager, 
who  enters  on  the  clearing-house  records  the  net  debit  and  credit 
balances  and  the  "On  Clearing  House"  and  "From  Clearing 
House"  totals.  He  then  foots  the  balances  and  if  they  prove  the 
clerks  arc  dismissed  and  return  to  their  respective  banks.  The 
statements  are  filed  as  a  record  of  the  transactions  between  the 
several  members,  and  the  manager  foots  the  "On"  and  "From" 
Clearing  House  columns;  and  if  they  agree  it  is  conclusive  evidence 
that  the  work  has  been  coiTCctly  done.  The  "On  Clearing  House" 
column  represents  the  items  brought  to  the  clearing  house  and  are 
the  figures  that  are  reported  in  the  newspapers  and  financial  jour- 
nals as  the  bank  clearings.  Where  an  average  of  $10,000,000  worth 
of  items  are  cleared  daily  the  resulting  balances  run  al)out  S600,000; 
so  by  the  operation  the  amount  of  cash  necessary  to  handle  SIO,- 
000,000  worth  of  business  is  reduced  from  .?  10,000,000  to  S600,000. 

The  next  step  is  the  settlement  of  balances.  One  plan  is  for  the 
manager  to  draw  checks  against  the  debtor  members  in  favor  of 
the  creditor  members;  the  first  check  being  drawn  against  the 
largest  debtor,  in  favor  of  the  smallest  creditor,  the  second  in 
favor  of  the  second  small  creditor,  and  so  on  do^^^l  the  line  until 
all  the  creditors  have  been  satisfied.  These  manager's  checks  are 
payable  in  cash  and  generally  must  be  settled  at  or  before  2  o'clock 
P.M.  of  the  day  on  which  dra\^-n.  In  case  of  failure  to  collect  any 
such  check  at  or  before  the  specified  hour,  all  members  other  than 
the  one  against  whom  the  check  is  drawn  are  released  from  re- 
sponsibility thereon.  To  simplify  the  payment  of  these  checks 
a  clearing-house  gold  depository  is  usually  maintained,  in  which 
members  deposit  gold  of  required  weight  and  United  States  gold 
certificates,  in  lieu  of  which  are  issued  :learing-house  gold  certifi- 
cates in  amounts  of  five  and  ten  thousand  dollars.  These  certifi- 
cates pass  current  among  the  members,  the  holders  thereof  being 
the  owners  of  tlie  gold  and  United  States  gold  certificates  so  de- 
posited and  wliich  count  as  legal  reserve.  In  settling  lialances  of 
$600,000  it  is  necessary  to  use  only  sixty  ten-thousjuid-dollar  gold 
certificates.  This  plan  saves  abrasion  on  the  gold  as  well  as  the 
labor  of  carrying  it  back  and  forth  and  recounting  it.  It  also 
eliminates  the  danger  of  street  robberies. 

The  manner  of  settling  clearing-house  balances,  and  the  forms  used, 
vary  slightly.  In  some  cities  the  ilebtor  banks  pay  the  cash  to  the 
manager  of  the  clearing  house,  and  he  in  turn  pays  it  to  the  creditor 
banks;  while  in  other  cities  the  creditor  banks  present  the  clearing- 


248  BANKING  AND   BUSINESS 

house  manager's  settlement  checks  to  the  debtor  banks  direct  for 
payment.  In  some  cities,  in  order  to  avoid  congestion  of  work  and 
to  head  off  check  kiting,  informal  exchanges  are  made  by  the 
members.  Receipts  are  taken  to  cover  items  so  exchanged  and  are 
passed  through  the  clearing  house  at  the  next  regular  exchange. 
Trading  of  balances  is  also  in  vogue  in  some  cities,  and  since  the 
inauguration  of  the  Federal  Reserve  system  many  balances  are 
settled  by  checks  on  Federal  Reserve  banks.  To  encourage  prompt- 
ness, care  and  accuracy  on  the  part  of  clerks,  fines  are  imposed 
for  errors  in  lists,  wrong  clearings,  missing  indorsements,  errors  in 
statements,  misconduct,  etc.  These  fines  range  from  ten  cents  to 
five  dollars,  and  are  assessed  against  banks  whose  representatives 
are  the  offenders.  The  proceeds  usually  go  toward  defraying  the 
general  expenses  of  the  association.  To  get  an  idea  of  the  con- 
venience and  saving  that  result  from  the  daily  exchanges  at  the 
clearing  house  one  need  only  to  consider  the  number  of  clerks  that 
would  be  required  to  go  from  bank  to  bank  and  collect  and  handle 
the  actual  cash  represented  by  $10,000,000  worth  of  items,  then 
compare  that  process  with  the  clearing  of  a  like  amount  of  items  and 
the  settlement  of  balances  resulting  therefrom. 

In  addition  to  the  function  of  city  clearings  there  is,  as 
has  ah-eady  been  noted,  in  quite  a  number  of  clearing 
houses  to-day,  a  country  department  whose  function  is 
essentially  that  of  collection.  In  principle  the  work 
of  the  country  department  differs  from  that  of  the  city 
chiefly  in  the  fact  that  deferred  rather  than  immediate 
debit  and  credit  is  given. 

IV.  Technic  of  National  Clearing. 

It  is  now  necessary  to  take  another  step  in  depicting 
the  clearing-house  system  of  the  United  States.  As 
explained  elsewhere  in  this  volume,  every  national 
bank  and  all  of  the  more  important  state  banks  and 
trust  companies  are  now  members  of  the  Federal 
Reserve  system,  and  as  such  each  bank  maintains  a 
specified  balance  on  the  books  of  the  Federal  Reserve 
bank  in  the  district  in  which  it  is  situated.  In  order 
to  re-estabUsh  such  a  balance  it  may  send  in  checks  or 


INTERBANK   RELATIONS  249 

drafts  upon  other  banks  which  have  agreed  not  to 
make  any  charge  to  the  Federal  Reserve  bank  for  col- 
lection. These  checks  or  drafts  are  credited  to  the 
account  of  the  member  bank  so  sending  them,  but 
only  after  enough  time  has  been  gi\'en  to  transmit 
them  to  the  banks  upon  which  they  are  drawn  and  to 
receive  back  funds  as  the  proceeds  of  the  item  thus 
assumed.  The  member  bank  is  supplied  with  a  sched- 
ule shomng  how  soon  it  will  have  credit  for  the  items 
drawn  on  the  different  points,  and  it  can  thus  keep 
very  close  track  of  the  balance  with  the  Reserve  bank 
from  day  to  day.  It  is  then  able  to  draw  upon  any 
accumulation  it  may  have  in  excess  of  required  reserve, 
and  thus  to  furnish  remittances  to  its  customers.  Such 
checks  drawn  upon  a  Reserve  bank  are  of  course  accept- 
able remittances  any\vhere. 

It  will  be  noted,  however,  that  a  Reserve  bank  which 
thus  accepts  checks  and  drafts  indiscriminately  from 
its  customers  will  probably  get  a  good  many  such  items 
drawn  on  banks  in  its  own  district  and  a  good  many 
drawn  on  banks  outside  of  its  district.  Those  drawn 
on  banks  within  its  own  district  it  can  largely  clear  upon 
its  own  books  by  mere  bookkeeping  entries,  or  through 
a  local  clearing  house  of  which  it  is  a  member.  Those 
drawn  on  banks  in  other  districts  it  can  clear  by  send- 
ing them  to  the  banks  in  the  other  districts  for  remit- 
tances of  similar  kind,  or  by  putting  them  through  the 
Reserve  bank  of  any  other  districts  and  leaving  it 
then  to  make  the  collection.  This  latter  process  is 
facilitated  by  what  is  called  the  gold-settlement  fund 
at  Washington,  which  is  a  fund  in  gold  deposited  with 
the  Treasury  Department  by  each  Federal  Reserve 
bank.  Daily  transfers  through  this  fund  are  made 
by  telegraph,  each  Reserve  bank  wiring  the  amount 
of  its  debits  and  credits  and  these  being  then  offset 
on  the  books  at  Washington,  so  that  the  relative  owner- 


250  BANKING  AND   BUSINESS 

ship  of  the  fund  varies  from  day  to  day,  but  without 
the  necessity  of  actually  shipping  gold  at  all.  Thus 
the  transfers  of  the  country  are  effected  by  simply  an 
easy  bookkeeping  process  which  practicall}''  clears 
between  clearing  houses.  It  is  still  true  that  a  good 
many  checks  go  through  the  local  clearing  house  and 
are  collected  by  it  either  directly  through  city  members 
or,  through  its  country  department,  from  out-of-town 
banks,  but  an  increasing  volume  of  checks  have  gone 
through  the  Reserve  banks  and  by  them  have  been 
cleared  on  their  own  books  or  through  the  gold- 
settlement  fund.  The  technic  of  clearing,  as  already 
explained,  is  simple  and  may  be  summed  up  in  the 
statement  that  it  is  nothing  more  than  a  bookkeeping 
process  in  which  plus  and  minus  items  are  canceled 
and  the  balance  is  paid  in  some  form. 

V.  International  Relationships  Among  Banks. 

What  has  been  said  thus  far  relates  primarily  to 
correspondent  relationsliips  between  banks  situated  in 
the  same  country.  The  international  relationship  of 
banks  which  act  as  correspondents  for  one  another  is 
very  similar,  but  is  necessarily  more  complex  and 
involves  more  responsibilities.  In  such  international 
relationships,  the  most  important  functions  to  be  per- 
formed are  those  of  mutually  acting  as  agents  for  one 
another  in  the  opening  of  credits,  thus  facilitating  the 
movement  of  goods  from  country  to  country,  while  the 
proceeds  of  collection  will  be  carried  on  open  account, 
or  remitted,  according  as  circumstances  dictate.  These 
are  what  are  technically  known  as  foreign-exchange 
transactions,  and  are  more  fully  dealt  with  elsewhere. 
It  is  worth  while  to  mention  them  at  this  point  because 
they  are  illustrative  of  interbank  relationships  in  the 
largest  sense,   and  because  they  are  precisely  on   a 


INTERBANK   RELATIONS  251 

parity  with  domestic  interbank  relationships.  The 
difference  lies  in  the  fact  that  in  international  trade 
there  is  more  call  for  the  actual  advancing  of  funds, 
while  differences  in  currency  units  and  values  involve 
a  greater  degree  of  responsibility  in  holding  such  funds. 
But  it  should  be  borne  in  mind  that  what  is  called 
''foreign  exchange"  as  conducted  at  the  present  time 
is  a  special  phase  of  interbank  business,  in  which  a  bank 
in  one  country  acts  as  collecting  agent  for  a  bank  in 
another,  and  frequently  adds  to  this  function  that  of 
rediscounting  or  purchasing  paper  or  assuming  the 
responsibility  for  credit  at  the  request  of  its  corre- 
spondent bank. 


CHAPTER  XVI 

FOREIGN   EXCHANGE 

I.  Meaning  of  Foreign  Exchange. 

The  subject  of  exchange,  whether  domestic  or  for- 
eign, may  be  studied  as  a  phase  of  economics,  com- 
merce, or  banking,  and  its  meaning  will  vary  with  the 
^'ie^vpoint  from  which  it  is  being  considered.  In  the 
broad  sense,  exchange  includes  commerce  itself  or  the 
interchange  of  goods.  From  a  more  restricted  stand- 
point, exchange  is  the  system  of  settHng  balances  arising 
out  of  these  commercial  transactions.  The  mechanism 
of  exchange  renders  unnecessary  the  sending  of  currency 
or  bullion  for  the  full  reimbursement  of  each  trans- 
action, and  payment  under  normal  economic  conditions 
is  made  to  cover  only  the  net  differences  between  the 
total  debits  and  credits.  In  its  narrowest  meaning, 
exchange  is  sunply  the  business  of  bujdng  and  selling 
claims  for  the  payment  of  money  at  a  particular  place. 
1  hese  definitions  apply  to  both  domestic  and  foreign 
exchange,  but  the  two  forms  differ  in  respect  to  coun- 
tries, currencies,  and  instruments  involved.  Domestic  ex- 
change settles  balances  arising  out  of  transactions  among 
individuals  Hving  in  the  same  country,  and  using  only 
one  form  of  currency,  but  through  instruments  which 
'are  orders  or  promises  to  pay  money  such  as  checks, 
drafts,  and  notes.  On  the  other  hand,  foreign  exchange 
effects  settlement  jr  the  business  transactions  of  resi- 
dents of  different  nations,  in  different  forms  of  money, 
and  only  thi-ough  orders  to  pay,  such  as  drafts,  bills 
of  exchange,  and  cable  transfers. 


FOREIGN   EXCHANGE  253 

A  bill  of  exchange  is  an  evidence  that  one  party  has 
a  claim  on  a  second,  and  that  this  debt  may  be  trans- 
ferred to  a  third.  As  an  illustration,  an  American  ex- 
porter, having  shipped  cotton  worth  S20,000  to  Eng- 
land, draws  a  draft  for  this  amount  on  the  importer. 
The  drawer  could  make  the  bill  payable  to  the  order 
of  himself,  but  it  is  more  likely  that  he  will  prefer  to 
have  this  money  at  his  disposal  in  New  "i'ork  in  the 
form  of  dollars,  and  therefore  he  sells  the  bill  to  some 
one  who  can  use  this  claim  to  discharge  a  debt  payable 
in  London.  The  drawer  transfers  his  claim  by  making 
the  bill  payable  not  to  himself,  but  to  the  purchaser. 

A  bill  of  exchange  may  be  considered  as  a  certificate 
representing  a  claim  to  a  certain  number  of  monetary 
units,  and  when  a  bill  covers  a  transaction  in  foreign 
trade  its  value  may  be  expressed  in  terms  of  other 
currencies.  The  common  basis  of  measurement  in  com- 
paring these  currencies  has  been  the  number  of  grains 
of  gold  in  the  monetary  units  of  the  nations  using  tliis 
metal  as  a  standard.  Since  the  pound  sterhng  contains 
113  grains  of  fine  gold,  and  the  dollar  but  23.22  grains, 
the  relative  value  of  one  sovereign  in  terms  of  United 
States  currency  is  S4.866.  This  is  the  muit  value  as 
fixed  by  the  governments,  and  is  known  as  the  mint 
price  or  the  par  of  exchange. 

II.  Demand  and  Supply  of  Foreign  Exchange. 

While  the  par  of  exchange  of  a  given  monetary  unit 
remains  practically  stationary,  the  market  price  or  rate 
of  exchange  fluctuates  daily.  As  in  the  case  of  any 
commodity,  the  market  price  or  rate  of  exchange 
of  any  country  varies  directly  with  the  demand,  and 
inversely  with  the  supply  of  bills  drawn  in  terms  of 
the  particular  currency.  This  demand  and  supply  is 
influenced  by  the  following  factors:    (1)  movement  of 


254  BANKING  AND  BUSINESS 

goods  and  bullion,  (2)  investment  of  capital,  (3)  pay- 
ment of  services. 

1.  Movement  of  Goods. 

When  American  firms  import  goods  from  abroad, 
they  may  make  payment  through  buying  bills  of  ex- 
change drawn  on  foreign  countries.  This  demand 
tends  to  raise  the  value  of  the  foreign  currency  as 
expressed  in  terms  of  United  States  money.  On  the 
other  hand,  when  American  traders  export  goods,  they 
may  draw  drafts  on  British  buyers  or  their  banks. 
Thus  a  supply  of  sterling  bills  is  created  in  the  New 
York  market  and  its  rate  is  inclined  to  fall.  Before 
1914  these  fluctuations  occurred  seasonally,  for  in  May, 
when  British  exports  to  the  United  States  were  at  their 
height,  sterHng  often  rose  to  about  $4.88,  while  in 
October,  when  American  grain  and  other  shipments  to 
England  were  heaviest,  the  sovereign  fell  to  $4.84. 

In  the  prewar  period  the  rate  of  sterling  seldom 
fluctuated  beyond  these  two  limits,  which  were  known 
as  the  gold  points.  A  bill  of  exchange  affords  a  claim 
upon  a  certain  amount  of  gold,  and  it  is  generally  more 
convenient  and  less  costly  to  use  this  instrument  than 
to  ship  buUion  itself.  However,  if  the  price  of  the  bill 
rises  to  an  amount  which  exceeds  the  value  of  the 
gold  plus  the  cost  of  its  shipment,  an  American  debtor 
who  wishes  to  discharge  an  obhgation  in  London  would 
prefer  to  export  the  gold  itself. 

The  expense  of  transporting  gold  bullion  between 
New  York  and  London  before  the  war  was  estimated 
at  two  cents  per  sovereign,  and  this  amount  included 
such  items  as  abrasion,  freight,  insurance  and  broker- 
age charges,  and  loss  of  interest.  Adding  this  sum  to 
the  par  of  exchange,  the  gold-export  point  was  $4,886. 
Conversely,  the  gold-import  point  on  London  was  the 
par  of  exchange,  $4,866  minus  $.02,  the  cost  of  ship- 


FOREIGN  EXCHANGE  255 

ping  gold  equaling  $4,846.  When  sterling  bills  fell 
below  this  rate,  an  American  creditor  who  held  claims 
on  London  did  not  wish  to  draw  a  draft  and  sell  it 
at  so  low  a  quotation  in  New  York,  but  preferred  to 
have  the  gold  itself  shipped.  Gold  import  and  export 
points  also  operated  in  other  countries  with  the  gold 
standard,  and  so  to  some  ext-ent  the  rates  on  bills  of 
exchange  for  francs  and  marks  moved  within  quite  a 
narrow  range.  The  international  flow  of  currency  and 
bulUon  was  not  entirely  free  even  before  1914,  for  gov- 
ernment control  in  most  countries  frequently  restrained 
the  export  of  gold.  Due  to  the  exigencies  of  the  war, 
beUigerent  countries  allowed  the  exchange  rate  of  their 
currency  to  depreciate  rather  than  permit  the  free 
movement  of  gold. 

2.  Movement  of  Capital, 

The  theory  of  the  classical  economists,  such  as  Adam 
Smith,  Ricardo,  and  Mill,  as  to  international  trade  held 
that  if  a  country's  exports  exceeded  its  imports  in  value, 
this  surplus  would  necessitate  the  influx  of  gold  to 
cover  the  difference.  While  it  is  true  that  over  a  long 
period  of  time,  credits  must  offset  debits  on  the  inter- 
national balance  statement,  it  should  be  noted  that 
merchandise  and  gold  are  not  the  only  items  which 
enter  into  the  financial  settlement  between  countries. 
They  are  only  the  visible  items,  and  in  addition  there 
are  several  invisible  factors  which  exert  considerable 
influence  on  the  rates  of  foreign  exchange.  An  impor- 
tant item  in  the  invisible  balance  is  the  movement  of 
capital  between  countries.  The  investment  of  funds 
in  foreign  securities  is  a  modern  phenomenon  in  eco- 
nomic history,  for  its  rapid  development  can  be  retraced 
only  to  the  beginning  of  the  nineteenth  century.  By 
this  time  the  industrial  revolution  had  multijjlied  the 
productive  power  of  business,  especially  in  England, 


256  BANKING  AND   BUSINESS 

and  had  resulted  in  the  accumulation  of  surplus  capital, 
which  was  attracted  into  enterprises  away  from  home 
because  of  larger  profits  and  higher  rates  of  interest. 
Among  the  factors  which  stimulated  international 
investment  are  the  following:  (1)  growth  of  railways, 
offering  opportunities  for  placement  of  capital,  (2)  the 
development  of  corporate  organization,  enabling  the 
gathering  of  capital  by  the  issue  of  stocks  and  bonds, 
(3)  improvement  in  communication  disseminating  in- 
formation concerning  foreign  economic  conditions,  and 
thus  giving  better  control  over  distant  investments. 

The  export  and  import  of  securities  affect  the  rate  of 
exchange  in  much  the  same  way  as  the  movement  of 
goods.  When  American  investors  purchase  British 
securities  these  may  be  paid  for  in  sterling,  and  thus  a 
demand  for  British  exchange  in  New  York  is  created, 
with  a  consequent  rising  tendency  in  the  rate  of  sterling. 
On  the  contrary,  when  British  capitalists  subscribe 
to  an  issue  of  Pennsylvania  Railroad  stocks,  these  are 
purchased  in  New  York,  where  the  supply  of  sterhng 
bills  is  increased,  causing  a  decline  in  the  rate  of 
sterling.  These  transactions  could  also  be  settled  in 
dollar  exchange.  British  securities  could  be  bought 
by  remitting  dollar  drafts  to  London,  where  the  sup- 
ply would  be  increased  and  its  value  would  fall  in  terms 
of  sterhng.  Likewise  the  purchase  of  American  se- 
curities could  be  made  by  British  investors  through 
buying  dollar  exchange  in  London  and  thus  causing  an 
appreciation  in  its  rates  as  expressed  in  sterhng. 

Dividend  and  interest  payments  would  naturally 
cause  a  movement  in  exchange  opposite  from  the  in- 
vestments themselves.  For  example,  the  semiannual 
payment  of  dividends  on  the  Pennsylvania  stock  men- 
tioned above  would  naturally  necessitate  settlement  by 
the  American  corporation  with  its  creditors  abroad. 
The  American  company  could  make  this  settlement 


FOREIGN   EXCHANGE  257 

by  purchasing  sterling  bills,  and  this  would  tend  to 
increase  the  demand  in  New  York  and  so  cause  a  rise 
in  the  price  of  sterling  in  terms  of  dollars. 

Since  1914,  governments  have  been  compelled  to 
borrow  heavily  and  so  have  floated  huge  issues  of 
securities  both  at  home  and  abroad.  These  govern- 
ments have  also  granted  loans  to  one  another,  and  in 
fact  the  European  countrie.-^^  owe  the  United  States  gov- 
ernment over  $11,000,000,000.  These  items  all  vitally 
affect  the  rates  of  foreign  exchanges. 

3.  Payment  of  Services. 

In  addition  to  securities,  the  invisible  balance  of 
trade  is  composed  of  other  items  such  as  charges  of 
foreign  shipowners  carrying  freight;  payments  to  for- 
eign companies  issuing  insurance  policies;  remittances 
of  immigrants  aiding  relatives  abroad;  disbursements 
of  tourists  traveling  for  pleasure.  Another  factor  which 
to-day  extensively  influences  rates  of  foreign  exchanges 
is  speculation.  It  is  applied  especially  to  depreciated 
currencies,  which  are  bought  and  sold  not  for  the  pur- 
poses mentioned  above,  but  solely  for  obtaining  profits 
from  a  rise  or  fall  in  rates.  Thus  at  the  present  time  the 
value  of  many  foreign  exchanges  is  not  fixed  by  normal 
factors,  but  by  unaccountable  speculative  influences. 

The  relative  significance  of  the  items  which  enter 
into  the  international  balances  of  the  United  States  is 
indicated  in  the  table  on  page  258. 

III.  Foreign-exchange  Market. 

These  forces  of  supply  and  demand  exert  their  in- 
fluence over  foreign  exchange  so  ciuickly  that  rates 
are  quite  uniform  all  over  the  world.  Thus  in  a  sense 
there  is  a  foreign-exchange  market  which  is  interna- 
tional in  scope.  It  is  composed  of  the  world's  financial 
centers,  such  as  New  York,  London,  Paris,  and  Berlin. 


258 


BANKING  AND  BUSINESS 


Statement  Showing  the  International  Balance  of  the  United 

States  on  October  1,  1921.  * 

[In  millions  of  dollars] 


Items 

1919 

1920 

1921  (9 
months). 

Total. 
Jan.  1. 
1919.  to 
Oct.  1. 
1921 

United  States,  creditor 

Excess  of  exports  of  merchandise 

Net  exports  of  gold  and  silver. . . 

Net  exports  of  Federal  Reserve 

notes 

4,016 
441 

91 

60 

220 

2,949 

103 
125 
140 

1,679 

150 
50 

8,644 

194 

Net  interest  payments  receivable 
(private)       

335 

Net  ocean  freight  payments  re- 
ceivable   

410 

Total  credit  items 

4,828 

3,317 

1,879 

9,583 

United  States,  debtor 

Net  imports  of  gold  and  silver.  . 

Net  imports  of  paper  currency . . 

Net   international   payments  of 
United  States  Government. . . 

Net  private  investment  of  Ameri- 
can capital  abroad.             ... 

2,375 

300 

150 

600 
50 

70 

305 

235 

125 

700 
150 

559 
100 

(') 

250 

40 

300 
125 

188 
100 

2,680 

785 

American    securities    resold    to 
United  States 

315 

Immigrants'  remittances  and  re- 
lief      

1,600 
325 

Tourists'  expenditures  

Total  debit  items 

3,475 

1,585 

1,374 

5,993 

Net  additions  to  unfunded  credit 
balance  of  the  United  States .  . 

Net   balance    on    open    account 
owed  by  United  States  on  Dec. 
31,  1918            

1,353 

1,732 

505 

3,590 

882 

Net  unfunded  credit  balance  of 
the  United  States  Oct.  1,  192P 

2,708 

*  Federal  Reserve  Bulletin  (1921),  p.  1263. 

'  Definite  figures  not  available. 

2  May  be  increased  to  $3,408,000,000  (see  Bulletin,  p.  1263). 


FOREIGN  EXCHANGE  259 

They  are  closely  bound  to  one  another  by  cable  and 
wireless  communication,  and  each  in  turn  is  supported 
in  its  foreign-exchange  operations  by  other  cities  in  the 
same  country  having  a  smaller  volume  of  business. 
Thus  Boston,  Chicago,  St.  Louis,  New  Orleans,  and 
San  Francisco  are  continually  transmitting  orders  for 
the  purchase  and  sale  of  foreign  exchange  to  New 
York  City. 

Here,  as  in  any  other  foreign-exchange  market, 
buyers  and  sellers  consist  of  business  firms,  investment 
houses,  commercial  banks,  and  brokers.  The  first 
group  includes  export  and  import  houses  handling 
goods,  while  the  second  is  composed  of  investment 
concerns  trading  in  stocks  and  bonds  on  an  inter- 
national scale,  and  so  both  groups  buy  and  sell  exchange 
as  a  subsidiary  part  of  their  regular  activities.  More 
directly  interested  in  foreign  exchange  are  the  various 
classes  of  banking  institutions  engaged  in  financing 
international  commerce.  A  bank  trades  in  exchange 
both  directly  and  indirectly.  It  deals  directly  with 
its  customers,  which  include  firms  in  foreign  trade  and 
correspondent  banks  without  their  own  foreign  depart- 
ment. However,  most  foreign-exchange  operations  are 
not  transacted  directly  between  buyers  and  sellers  of 
bills,  but  indirectly  through  brokers  who  act  as  inter- 
mediary agents  between  merchants  and  bankers  and 
between  bankers  themselves. 

IV.  Classes  of  Foreign-exchange  Bills. 

Bills  of  exchange  bought  and  sold  on  the  market  are 
classified  primarily  according  to  whether  the  parties 
are  bankers  or  merchants.  A  banker's  bill  is  an  order 
drawn  by  one  bank  on  another  to  pay  a  specified  sum 
of  money.  The  drawee  bank  is  usually  a  c<)rrcsj)ond- 
ent  carrying  a  balance  previously  deposited  by  the 


260  BANKING  AND  BUSINESS 

drawer.  The  usance  of  the  bill  may  be  either  sight  or 
time.  As  a  banker's  sight  bill  is  drawn  on  a  bank  and 
is  also  payable  on  demand,  it  possesses  the  features 
of  an  ordinary  check  and  is  frequently  known  by  that 
name.  It  is  in  every  respect  a  negotiable  instrument, 
and  is  usually  payable  to  the  order  of  a  party.  This 
sight  draft,  or  check,  is  used  when  a  bank  sells  foreign 
exchange.  As  an  illustration,  a  person  in  New  York, 
wishing  to  send  £100  sterling  to  London,  purchases 
this  amount  of  foreign  exchange  from  his  bank,  which 
generally  gives  him  a  draft  drawn  against  its  balance 
with  a  British  correspondent.  The  purchaser  then 
forwards  the  draft  by  mail  to  the  payee,  who  receives 
the  money  on  presenting  the  instrument  to  the  drawee 
bank  in  London.  In  large  transactions  where  quick 
communication  is  necessary,  or  in  time  of  war  when 
international  mail  service  is  uncertain,  the  cable  trans- 
fer is  used.  As  it  is  an  order  given  by  a  bank  to  its 
correspondent  to  pay  an  amount  of  money  on  demand, 
the  cable  transfer  is  simply  a  form  of  banker's  check. 
The  two  forms  of  exchange  differ  in  that  the  cable 
transfer  is  forwarded  over  cable  or  wireless  by  the 
selling  bank  directly  to  the  payee,  while  the  check  is 
given  by  the  bank  to  the  purchaser,  who  himself 
undertakes  the  responsibility  of  transmitting  it.  Fur- 
thermore, the  cable  transfer  is  payable  only  to  a  speci- 
fied party  and  is  thus  nonnegotiable,  Thile  the  check  is 
usually  drawn  to  order  and  is  thei-fore  transferable. 

Bankers'  bills  drawn  on  a  time  b  sis  state  that  pay- 
ment will  be  made  on  a  certain  date  or  a  number  of 
days  after  sight.  These  time  bills  are  further  grouped 
according  to  whether  the  maturity  is  over  thirty  days. 
If  less,  they  are  called  short  bills;  if  over,  they  are 
termed  long  bills.  Drafts  of  the  latter  type  usually 
have  a  maturity  of  sixty  or  ninety  days,  and  seldom 
more  than  one  hundred  and  twenty. 


FOREIGN   EXCHANGE  261 

Bankers'  bills  may  also  be  classified  according  to  the 
purpose  for  which  they  are  drawn.  As  indicated  above, 
a  bank  in  the  course  of  its  business  creates  foreign- 
exchange  bills  to  cover  shipment  of  goods,  reimbursing 
of  freight  charges,  meeting  of  insurance  premiunxs,  for- 
warding of  remittances,  and  pajdng  of  tourists'  expenses. 
Of  a  different  nature  are  those  bills  drawn  in  order  to 
lend  funds  in  a  foreign  money  market.  These  advances 
are  described  as  loan  bills  when  supported  by  collateral, 
and  ai'e  termed  finance  bills  when  based  only  on  pure 
credit. 

Trade  bills  are  instruments,  the  parties  to  which  are 
merchants.  These  bills  are  classified,  in  general,  accord- 
ing to  time  and  purpose.  Demand  bills  can  be  drawn 
only  by  firms  with  extensive  foreign  business,  but 
greater  use  is  made  of  time  drafts.  These,  in  turn,  are 
either  long  or  short,  depending  upon  whether  their 
maturity  is  more  or  less  than  thirty  days.  As  to  pur- 
pose, bills  drawn  by  conmiercial  houses  follow  a  classi- 
fication quite  different  from  that  of  bankers'  bills. 
Drafts  which  arise  from  the  reimbursement  of  services 
cannot  very  well  be  accompanied  by  any  documents 
representing  property  which  could  serve  as  collateral. 
Such  bills  are  described  as  clean  or  unsecured,  and  so 
their  value  depends  entirely  upon  the  credit  standing 
of  the  drawer  and  also  the  acceptor.  This  group  also 
includes  all  bills  from  which  documents  have  been 
detached.  Of  greater  importance  in  foreign  exchange 
are  drafts  coUateraled  by  certificates  or  documents 
evidencing  the  ownership  of  some  form  of  property, 
and  which  therefore  are  called  documentary,  or  secured 
bills.  Secured  bills  may  be  ])rotected  by  stocks  and 
bonds  which  have  been  ordered  by  foreign  in\'estors 
and  are  surrendered  to  them  upon  their  honoring  the 
accompanying  bills  of  exchange. 

All  documentary  drafts  are  based  on  the  shipment 


262  BANKING  AND   BUSINESS 

of  merchandise.  The  shipping  documents  thus  attached 
to  the  bills  are  known  as  the  "commercial  set"  and 
include  bills  of  lading,  insurance-policy  certificate, 
commercial  invoice,  and  several  miscellaneous  certifi- 
cates of  minor  importance. 

Possession  of  the  documents,  especially  the  bills  of 
lading,  is  necessary  before  the  importer  is  able  to  obtain 
the  merchandise.  If  his  credit  is  insufficient  or  if  the 
merchandise  is  not  readily  marketable,  the  documents 
are  surrendered  only  upon  full  payment  of  the  drafts 
by  the  purchaser.  If,  on  the  other  hand,  his  standing 
is  satisfactory  or  if  the  goods  are  staples,  as  cotton 
or  wheat,  which  can  be  sold  readily,  the  documents 
are  delivered  upon  the  acceptance  of  the  drafts  by  the 
importer  or  by  his  bank. 

In  sunmiary,  the  various  forms  of  foreign  exchange 
may  be  grouped  as  follows: 

Classification  of  Forms  of  Foreign  Exchange 
according  to 

— drawer        — time  — purpose  — security 

i  sight     I  cable  transfer    /  sale  of  goods 
j  1  mail  I  services 

bankers  <  ]  remittances 

time      I  short  1  j       loan 

1  long  /  \  (secured) 

\  advances  < 

/    finance 
I  (misecured) 


clean 


commercial  \    ^ 

,         J  sale  of  goods      ] 

I  time      I  short  services  j  documentary 

I  long  '      on  accept- 

ance 
on  pay- 
ment 


FOREIGN   EXCHANGE  263 

Y.  Factors  Determining  Rates  on  Various  Classes 
OF  Bills. 

The  rates  quoted  on  the  leading  types  of  these  bills 
are  indicated  in  the  following  table: 

Rates  on  Sterling  Bills  on  October  4,  1921 

Classes  of  Bills  Closing  Rates 

Bankers'  ninety  clays $3 .  65 

Bankers'  sixty  days 3 .  67 

Demand  sterling 3.723^ 

Cable  transfers 3 .  73)^ 

Bills- 
Grain  3.713^ 

Commercial,  sight 3 .  72^ 

Documents  for  payment,  sixty  days,  against 

grain 3 .  66^ 

Commercial  ninety  days 3 .  62  J^ 

Commercial  sixty  days 3 .  64^ 

The  variations  found  in  the  above  rates  on  foreign 
bills  are  due  largely  to  the  element  of  tune,  and  conse- 
quently of  interest,  which  enters  into  the  remitting  of 
drafts.  Banks  quote  the  highest  rate  on  their  cable 
transfers,  for  these  orders  are  payable  immediately 
upon  presentation  by  the  payee.  In  the  case  of  a 
sterling  cable  transfer,  only  a  few  hours  elapse  between 
the  sale  by  the  bank  in  New  York  and  the  surrender  of 
funds  to  the  beneficiary  in  London.  A  demand  draft 
is  forwarded  by  mail,  and  even  on  the  fastest  steamer 
it  reaches  the  paj'ee  at  least  after  seven  days  have 
passed.  Meantime  the  bank  which  sells  the  draft  has 
full  use  of  this  portion  of  its  foreign  balance,  and  is  thus 
able  to  quote  a  cheaper  price  on  demand  drafts  than 
on  cable  transfers.  From  the  aboxe  table  it  is  seen 
that  the  greater  the  difference  of  time  in  which  the 
funds  become  available,  the  lower  is  the  quotation 

18 


264  BANKING  AND  BUSINESS 

on  the  bill  because  of  the  difference  in  the  interest 
charge.  The  element  of  time,  and  therefore  of  in- 
terest, does  not  enter  into  the  quotation  on  cable 
transfers,  which  represent  the  exact  market  relation- 
ship between  dollars  and  sterling  in  the  above  table, 
or  between  any  two  other  currencies.  The  cable- 
transfer  rate,  therefore,  is  fundamental  in  determining 
the  price  of  all  other  bills. 

Rates  on  the  various  classes  of  bills  are  determined 
also  by  the  extent  of  the  credit  risk  involved.  The  credit 
factor  is  usually  of  minor  influence  in  fixing  the  rates 
on  bankers'  bills.  They  are  called  prime  bills  when 
accepted  by  the  stronger  institutions,  and  all  are 
usually  considered  of  the  same  value.  If  a  bank  should 
place  upon  the  discount  market  a  volume  of  bills 
unwarranted  by  its  resources,  such  pohcy  would  soon 
operate  to  depress  rates  quoted  on  its  drafts.  A  dif- 
ferentiation is  sometimes  made  between  one-name  and 
two-name  bankers'  bills.  Those  drawn  by  a  bank  on 
its  foreign  branch  or  on  an  affiliated  institution  will 
ordinarily  bring  a  lower  rate  of  exchange  because  of  the 
identity  between  drawer  and  acceptor,  and  the  conse- 
quent single  responsibihty  of  the  parties  to  the  instru- 
ment. When  a  first-class  bank  draws  on  a  separate 
institution  of  standing,  the  accepted  bill  gives  the 
holder  a  twofold  security,  and  therefore  commands  a 
higher  price  in  terms  of  foreign  money. 

Trade  bills  drawn  by  mercantile  houses  on  other 
business  concerns  vary  in  their  market  quotations 
according  to  the  credit  standing  of  the  parties.  Drafts 
of  less-known  or  doubtful  firms  are  sold  only  with 
difficulty.  These  bills  may  at  times  find  a  market  if 
they  are  based  on  staple  goods  which  are  nonperishable 
and  in  active  demand.  The  value  of  such  drafts  is  then 
determined  not  by  the  credit  standing  of  the  parties, 
but  by  the  security  in  the  goods. 


FOREIGN    EXCHANGE  265 

VI.    FOKEIGN-EXCHANGE   QUOTATIONS. 

As  foreign-exchange  trading  has  no  organized  mar- 
ket where  dealers  are  in  personal  contact  with  one 
another,  prices  are  not  exactly  unifomi,  and  so  there 
are  several  kinds  of  c[uotations.  As  in  any  market, 
there  is  alwaj^s  a  "bid"  price  at  which  the  prospective 
purchaser  offers  to  buy,  and  an  "asked"  price  at  which 
the  seller  is  satisfied  to  make  the  sale.  In  foreign 
exchange,  the  former  price  is  known  as  the  bank's 
bujdng  rate,  and  the  latter  as  the  selling  rate.  Be- 
tween these  two  rates  there  is  a  difference  or  "spread" 
which  represents  the  bank's  profits.  Actually  the 
bank  does  not  quote  the  same  buying  or  selling  rate  to 
all  customers,  for  these  quotations  will  differ  according 
to  the  value  of  the  account  to  the  bank  and  the  size  of 
the  transaction.  The  "market"  quotation,  which  ap- 
proaches closely  the  actual  daily  buying  or  selling 
rate,  is  given  by  the  bank  to  large  commercial  houses 
only  for  wholesale  orders  for  exchange.  For  smaller 
or  retail  transactions  involving  the  remitting  of  funds 
by  individuals,  the  bank's  quotations  are  naturally 
higher.  All  these  quotations  represent  actual  offers 
on  the  part  of  the  bank  to  buy  or  sell  exchange,  and  so 
are  called  "firm"  rates.  Banks  also  issue  "service" 
rates  to  their  customers  as  a  matter  of  market  informa- 
tion, but  not  as  a  real  offer  or  a  bid  for  exchange. 

The  rates  presented  on  page  263  are  quoted  by  the 
direct  method,  which  states  the  number  of  home  units 
payable  for  one  foreign  unit.  Thus  $3.65  is  the 
equivalent  of  one  pound  sterling.  Foreign-exchange 
rates  may  also  be  quoted  indirectly,  and  in  this  case 
the  value  of  one  home  unit  is  expressed  in  terms  of  the 
number  of  foreign  units  which  it  commands.  Before 
1914,  one  dollar  was  the  equivalent  of  5.18  francs. 
For  many  years  both  methods  of  quoting  rates  were 


266  BANKING   AND   BUSINESS 

employed  in  the  foreign-exchange  markets,  but  in 
order  to  avoid  confusion  the  dealers  of  the  New  York 
market  in  1921  agreed  to  use  only  direct  quotations, 
and  thus  all  rates  for  foreign  currencies  are  quoted  in 
dollars  or  in  cents. 


VII.  Trading  in  Foreign  Exchange. 

The  buying  and  selHng  of  foreign  bills  of  exchange  is 
known  as  trading.  In  performing  this  function  the 
banker  acts  as  middleman  between  those  who  have 
bills  to  sell  and  those  who  wish  to  buy.  The  banker 
does  not  actually  resell  the  identical  bill  from  one  party 
to  the  other,  but  sends  the  purchased  bills  abroad  to  be 
collected  by  his  correspondent,  who  credits  the  pro- 
ceeds to  the  account  of  the  sender.  In  buying  bills, 
the  banker  increases  his  balance  in  foreign-money 
centers  and  so  creates  a  fund  which  may  be  regarded 
as  his  supply  of  foreign  exchange.  These  foreign- 
exchange  balances  are  reduced  through  sales  of  ex- 
change. Thus  a  purchase  of  exchange  is  a  credit  added 
to  the  banker's  balance  abroad  and  a  sale  is  a  debit. 

The  orders  which  a  bank  receives  for  buying  and 
selling  foreign  exchange  are  executed  or  filled  in 
various  periods  of  time.  A  spot  delivery  necessitates 
the  immediate  surrender  of  the  draft  by  the  seller. 
In  the  case  of  a  prompt  delivery,  several  days  are 
allowed  for  completing  the  delivery.  A  third  type  is 
arranged  in  what  is  known  as  a  future,  or  ''forward," 
contract,  which  is  an  agreement  by  a  bank  to  purchase 
or  sell  a  certain  amount  of  foreign  exchange  at  a  fixed 
rate  for  delivery,  not  at  the  present  time,  but  on  a 
specified  date  in  the  future.  The  interval  between 
the  actual  purchase  of  the  exchange  and  its  eventual 
delivery  may  extend  from  several  days  to  several 
months. 


FOREIGN   EXCHANGE  267 

The  procedure  in  selling  a  future  exchange  may  be 
illustrated  by  a  typical  transaction.  For  example,  in 
April  the  American  Cotton  Exporting  Company  sells 
to  the  British  Importing  Company  a  consignment  of 
cotton  worth  £10,000  for  shipment  in  July.  The 
American  firm  is  unwilling  to  assume  the  risk  of  loss 
through  fluctuation  in  the  value  of  sterUng,  and  prefers 
to  know  exactly  what  the  transaction  will  be  worth  in 
July  as  expressed  in  dollars.  The  American  Exporting 
Company  is  in  possession  of  a  certain  amount  of  future 
exchange  which  it  desires  to  sell,  and  so  approaches  the 
banks  directly  or  indirectly  through  a  broker,  until  it 
finds  a  purchaser  who  accepts  the  exchange.  In  Jul>' 
the  exporting  company  ships  the  cotton,  draws  a  draft 
on  the  importer,  and  delivers  the  bill  with  the  shipping 
documents  to  the  bank  which  has  previously  agreed 
to  purchase  it.  The  bank  examines  the  draft  and 
documents,  compares  them  with  the  contract  or  agree- 
ment made  in  April,  and  if  all  conditions  have  been 
fulfilled,  it  pays  the  exporter  for  his  draft,  which  is  then 
forwarded  abroad.  In  this  transaction  the  exporter 
bears  only  the  conmnercial  risk  arising  from  fluctuations 
in  commodity  prices,  while  the  banker  assumes  the 
exchange  risk  resulting  from  the  variations  in  the 
rates. 

The  bank  is  not  compelled  to  carry  this  risk  if  it 
follows  a  policy  of  hedging  or  covering.  A  cautious 
bank  will  so  arrange  its  trading  as  to  make  sales  and 
purchases  of  exchange  simultaneousl}^  and,  since  debits 
will  thus  offset  credits,  its  foreign  balances  will  remain 
stationary.  Profits  will  then  be  confined  to  the  dif- 
ference between  the  selling  and  the  buying  rate  on 
bills. 

The  bank  may  at  times  seek  larger  profits  by  specu- 
lation in  exchange,  in  what  is  known  as  "taking  a 
position  on  the  market."    A  bank  may  follow  a  policy 


268  BANKING  AND  BUSINESS 

of  going  ''long"  on  the  market  through  buying  bills 
at  the  prevailing  rate  and  afterward  selling  them  at 
a  profit,  provided  the  rate  has  risen  in  the  meantime. 
The  "short"  side  may  also  be  taken  by  selling  bills  at 
the  current  price  in  anticipation  of  a  fall  in  the  rate, 
thus  enabling  the  repurchase  of  drafts  later  at  a  lower 
quotation.  These  transactions  are  the  same  as  the 
ordinary  forms  of  speculation  which  seek  to  obtain 
profits  from  differences  in  prices  in  the  same  market  at 
different  times. 

Another  type  of  foreign-exchange  speculation  involv- 
ing comparatively  Httle  risk  is  known  as  "arbitrage"; 
it  is  based  on  profits  which  arise  from  prices  quoted  in 
different  markets,  but  quoted  all  at  the  same  time.  As 
in  any  other  foreign-exchange  operation,  the  aim  is  to 
buy  at  the  lowest  price  and  sell  at  the  highest  rate. 
This  object  is  usually  accomplished  by  buying  one  kind 
of  currency  directly  with  a  second,  such  as  francs  with 
dollars.  An  arbitrage  transaction,  however,  results  in 
a  trade  indirectly  through  a  third,  or  intermediary, 
market.  Assume  that  in  New  York,  on  a  certain  day, 
the  franc  is  worth  19.25  cents,  and  the  pound  sterUng 
$4.86.  In  London,  on  the  same  day,  francs  are  quoted 
at  25.25  for  one  pound  sterling.  While  2,522  francs  in 
New  York  cost  $486,  it  would  be  cheaper  to  trade  in 
the  London  market,  where  $486  (worth  £100)  will 
buy  2,525  francs.  Thus  a  profit  of  three  francs  would 
result.  When  only  three  markets  are  involved  as  in 
this  illustration  the  transaction  is  kno^Ti  as  a  simple 
arbitrage.  A  compound  arbitrage  affects  four  or  more 
centers.  Arbitrage  is  also  used  in  the  investment  field. 
When  a  security,  as  United  States  Steel,  is  selling  at 
a  higher  rate  in  London  than  in  New  York,  it  may  be 
worth  while  to  cable  an  order  to  sell  shares  in  London 
and  at  the  same  time  cover  this  transaction  through 
buying  an  equal  amount  of  the  stock  on  the  New  York 


FOREIGN   EXCHANGE  269 

Exchange.  Besides  securities,  the  principle  of  arbitrage 
may  be  applied  in  buying  and  selling  bullion  or  any 
other  commodity  which  has  a  free  international  mar- 
ket. Arbitrage  tends  to  neutralize  wide  fluctuations 
in  rates,  by  ehminating  differences  in  rate,  and  thus 
bringing  prices  near  to  equahty  in  all  markets. 


CHAPTER  XVII 

FINANCING   FOREIGN   TRADE 

I.  Special  Nature  of  Foreign  Trade  Finance. 

In  the  preceding  chapter  foreign  exchange  was  con- 
sidered in  its  appUcation  to  all  forms  of  international 
business  such  as  shipment  of  goods,  sale  of  securities, 
and  payment  of  services.  In  this  chapter  attention 
will  be  given  only  to  the  methods  of  financing  the 
export  and  import  of  goods. 

The  financing  of  foreign  trade  is  a  problem  difficult 
for  both  merchants  and  bankers  because  of  their  inabil- 
ity to  determine  the  credit  standing  of  foreign  buyers. 
It  is  practically  impossible  to  secure  information  from 
these  firms  themselves,  since  the  use  of  the  credit  state- 
ment is  fittle  known  outside  the  United  States.  The 
necessary  facts  must  be  gathered  by  indirect  means. 
In  this  work,  correspondent  banks  and  branch  offices 
are  called  upon  to  express  their  judgment,  but  these 
responses  generally  furnish  httle  information,  for  they 
are  based  on  personal  opinions  rather  than  on  credit 
files.  The  general  mercantile  agencies,  as  Dun  and 
Bradstreet,  have  extended  their  organizations  to  foreign 
fields  and  are  developing  a  credit  service  similar  to  that 
established  in  the  United  States.  Because  of  difference 
in  nationahty,  local  feeling  against  supplying  informa- 
tion, and  distance  between  the  two  countries,  very 
Uttle  knowledge  can  be  gathered  about  the  credit  stand- 
ing of  the  merchant. 

This  lack  of  credit  information  concerning  commer- 


FINANCING  FOREIGN   TRADE       271 

cial  houses  vitally  affects  the  nature  of  foreign  trade 
financing,  and  differentiates  it  from  the  procedure  used 
in  domestic  commerce.  In  the  first  place,  banking  insti- 
tutions are  relatively  more  important  in  international 
trade,  for  it  is  necessary  to  use  their  better-known 
credit  in  place  of  the  limited  standing  of  the  commer- 
cial houses  in  order  to  induce  sellers  to  part  with  their 
goods. 

II.  Documents  in  Foreign  Trade. 

In  addition  to  what  precedes,  the  absence  of  credit 
knowledge  limits  the  amount  of  unsecured  loans  ex- 
tended in  foreign  trade  and  therefore  most  advances 
are  based  on  some  form  of  collateral.  In  the  movement 
of  goods,  this  security  hes  in  the  shipping  documents 
which  accompany  the  drafts  dra\Mi  by  the  exporters. 
Because  of  the  prime  significance  of  these  documents 
in  all  phases  of  foreign  trade  finance,  they  will  be  con- 
sidered at  the  outset.  The  shipping  documents  atr- 
tached  to  the  drafts  include,  as  a  rule,  the  bill  of  lading, 
insurance  poUcy  or  certificate,  commercial,  consular 
invoice  and  several  miscellaneous  certificates  of  minor 
importance.  Most  essential  of  the  entire  set  is  the  bill 
of  lading,  which  performs  two  distinct  functions.  In 
the  first  place,  it  serves  as  a  receipt  from  the  transpor- 
tation company  that  the  goods  have  been  accepted  for 
carriage  and  will  be  deli\'ered  to  their  destination.  It 
is  used  also  as  a  document  which  indicates  the  oN\'ner •• 
ship  of  the  goods. 

These  two  functions  offer  a  basis  for  classifying  bills 
of  lading  according  to  carrier  and  to  negotiability. 
Bills  of  lading  may  be  of  the  following  kinds:  (1)  rail- 
road, for  goods  mo\'ed  bj'  rail  between  domestic  points; 
(2)  ocean,  for  freight  shipped  on  board  a  vessel  to  for- 
eign countries;  and  (3)  through,  for  merchandise  trans_ 


272  BANKING  AND   BUSINESS 

ported  by  both  rail  and  steamship  or  two  different 
steamship  lines  from  inland  to  foreign  points.  Bills 
of  lading  are  not  necessarily  negotiable.  The  straight, 
or  nonnegotiable  form  is  filled  out  in  the  name  of  a 
specified  party,  known  as  the  consignee,  who  has  the 
right  to  demand  delivery  of  the  shipment  from  the 
carrier  without  even  producing  the  bills  of  lading.  This 
type  offers  no  security  to  the  banker  who  has  acquired 
an  interest  in  the  goods  through  granting  a  loan  to  the 
shipper  or  consignor.  A  negotiable  bill  of  lading  only  is 
regarded  as  satisfactory  collateral  for  a  lending  bank,  as 
this  document  must  first  be  presented  to  the  carrier 
before  the  consignee  or  any  other  party  can  take  pos- 
session of  the  goods.  Bills  of  lading  are  drawn  directly 
to  the  shipper's  order,  or  in  blank  and  then  indorsed 
by  him.  In  this  way  the  bank  holding  one  or  more 
copies  controls  the  ownership  of  the  goods  and  can 
transfer  this  title  by  mere  indorsement.  Bills  of 
lading  can  be  forged  easily  by  freight  agents  acting  in 
collusion  with  unscrupulous  shippers,  and  in  conse- 
quence banks  suffered  heavy  losses  for  many  years. 
The  Knight- Yancey  cotton  frauds  alone  cost  the  banks 
several  millions  of  dollars  through  payments  made  on 
bills  of  lading  which  were  supposed  to  represent  ship- 
ment of  cotton,  but  which,  in  fact,  were  forgeries  by 
railroad  employees.  To  prevent  the  recurrence  of  these 
practices  and  to  protect  the  rights  of  banks  discounting 
drafts  accompanied  by  bills  of  lading.  Congress  passed 
the  Federal  Bill  of  Lading  Act  which  became  effective 
on  January  1,  1917.  Among  other  provisions,  this 
statute  holds  the  carrier  responsible  for  any  bill  of 
lading  issued  by  its  agents,  whether  the  instrument  be 
true  or  fraudulent. 

The  second  document  in  the  commercial  set  is  the 
marine- insurance  poUcy.  This  is  a  contract  whereby 
a  merchant  or  a  shipowner  is  indemnified  by  an  under- 


FINANCING   FOREIGN   TRADE       273 

TNTiter  or  assurer  in  event  of  loss  sustained  by  the  as- 
sured party.  Insurance  is  not  taken  out  to  cover 
goods  transported  by  rail,  for  under  American  law  a 
domestic  carrier  is  fully  liable  for  goods.  This  statute 
does  not  affect  an  ocean  steamship  company,  which 
assumes  very  few  of  the  many  risks  encountered  in 
conveying  merchandise  overseas.  In  forwarding  a 
number  of  shipments,  the  sender  usually  applies  to  the 
insurance  company  for  an  open  or  floating  policy  cover- 
ing all  transactions,  and  under  this  general  contract 
a  separate  insurance  certificate  is  drawn  to  apply  to 
each  shipment.  In  time  of  hostilities,  shippers  also 
insure  their  goods  against  war  risk.  Since  the  close  of 
the  war  mine-risk  policies  have  been  continued  in 
order  to  indemnify  owners  of  merchandise  against 
possible  loss  from  floating  mines. 

Third  in  the  set  of  documents  accompanying  a 
foreign  bill  is  the  commercial  invoice.  This  instru- 
ment contains  a  complete  description  of  the  merchan- 
dise, the  terms  under  which  it  has  been  sold,  and  the 
parties  involved.  The  invoice  states  the  quality  and 
quantity  of  the  goods  in  detail,  the  price  and  all  dis- 
counts, together  with  the  names  of  the  buyer  and 
seller  and  any  agent  who  may  have  been  party  to  the 
sale.  The  commercial  invoice  is  of  particular  interest 
to  the  bank,  which  learns  the  price  paid  for  the  goods 
and  is  thereby  aided  in  judging  the  extent  of  the  loan 
to  be  granted  on  this  security. 

In  addition  to  the  bill  of  lading,  insurance  policy, 
and  commercial  invoice,  a  foreign  draft  may  also  be 
accompanied  by  several  other  documents.  In  order  to 
secure  the  entry  of  goods  into  certain  countries,  it  is 
necessary  to  obtain  a  consular  invoice  in  which  the 
government  representative  of  the  importing  country 
certifies  to  the  origin  of  the  goods  and  their  current 
value  as  expressed  in  the  market  of  the  exporting 


274  BANKING   AND   BUSINESS 

country.  The  consular  invoice  can  be  used  by  customs 
officers  of  the  importing  country  as  a  means  of  levying 
ad  valorem  tariff  duties  which  are  based  on  the  selling 
price  of  the  goods.  Governments  sometimes  insist  upon 
a  health  certificate  which  certifies  to  the  sanitary  con- 
dition of  certain  classes  of  exports  which  may  carry 
contagious  disease.  This  statement  is  required  espe- 
cially in  the  case  of  hides  and  skins  in  order  to  guard 
against  the  spread  of  anthrax.  Importers  often  demand 
certificates  of  weight,  measure,  and  analysis  so  as  to 
assure  themselves  that  they  will  receive  merchandise 
of  the  quantity  and  quahty  specified  in  the  contract 
of  sale.  Finally,  the  banker  who  purchases  the  bill 
may  exact  from  the  exporter  a  letter  of  hypothecation, 
which  recognizes  the  assignment  of  all  the  above  docu- 
ments, and  thereby  the  ownership  of  the  goods,  to  any 
holder  of  the  draft. 

III.  Financing  of  a  Shipment  by  the  Exportek  or 
His  Bank. 

The  burden  of  financing  a  shipment  of  goods  may  be 
carried  by  the  exporter,  the  importer,  or  their  respective 
banks.  The  exporter's  bank  finances  the  transaction 
when  it  discounts  his  draft  drawn  on  the  buyer,  for 
in  purchasing  the  bill  the  bank  pays  cash  for  it  or 
credits  the  exporter's  account  with  the  amoimt.  The 
procedure  is  quite  similar  to  that  of  discounting  com- 
mercial paper  in  domestic  business.  The  bill  is  offered 
for  purchase,  and  if  the  credit  of  the  parties  as  well  as 
the  value  of  the  goods  proves  satisfactory,  the  bank 
will  deduct  the  discount  charge,  dehver  the  proceeds 
to  the  drawer  of  the  draft,  and  collect  the  full  amount 
from  the  drawee.  The  bank  as  bona-fide  holder  of  the 
bill  expects  to  receive  payment  from  the  di'awee,  and, 
if  he  dishonors  the  bill,  reimbursement  will  be  demanded 
from  the  drawer. 


FINANCING  FOREIGN   TRADE       275 

Foreign  bills  drawn  by  the  exporter  may  be  given 
to  his  bank  for  collection,  and  in  this  case  the  customer 
does  not  receive  credit  to  his  account  until  the  proceeds 
of  the  draft  have  been  remitted  from  abroad.  Com- 
pared with  a  bill  held  by  the  bank  for  collection,  a 
discounted  draft  may  be  regarded  as  a  cash  item,  since 
the  customer  receives  immediate  credit.  A  further 
difference  between  these  two  instruments  is  to  be  found 
in  the  legal  position  of  the  bank,  for  it  is  the  owner  of 
the  purchased  bill,  while  in  the  forwarding  of  a  collection 
item  it  is  acting  merely  as  an  agent  of  the  exporter. 

Collection  items  may  cover  all  kinds  of  foreign- 
exchange  transactions  such  as  the  handling  of  ship- 
ments, loans,  remittances,  and  insurance,  but  for  the 
purpose  of  this  chapter  only  the  first  need  be  consid- 
ered. A  bill  is  forwarded  to  the  bank  for  collection 
rather  than  for  purchase,  when  the  exporter  has  suffi- 
cient capital  to  finance  the  transaction  liimself  and  is 
thus  able  to  save  the  discount  charge.  At  times  the 
bank  is  unwilling  to  buy  the  bill  outright  because  the 
credit  standing  of  the  parties  does  not  warrant  this 
step,  or  the  underlying  merchandise  is  not  readily 
marketable. 

Both  discounted  and  collection  bills  are  forwarded  in 
much  the  same  manner.  They  are  transmitted  to  a 
foreign  correspondent  bank,  which  presents  them  to  the 
drawee,  who  accepts  or  pays,  whichever  the  case  may 
be,  and  then  the  funds  are  either  remitted  to  the 
American  bank  or  credited  to  its  account.  Upon 
receipt  of  the  cash  or  the  credit,  the  American  bank 
deducts  the  charges  for  collection  and  turns  the  remain- 
ing proceeds  of  the  bill  over  to  the  exporter. 

The  burden  of  financing  a  shipment  of  goods  may 
be  carried  by  the  exporter  and  his  bank  jointly  by  what 
is  known  as  an  advance  collection.  The  bank  may 
receive  the  bill  for  collection,  and  use  the  instrument 


276  BANKING  AND  BUSINESS 

as  collateral  to  lend  the  exporter  about  70  or  80  per 
cent  of  the  face  amount.  When  the  draft  is  finally 
collected  the  bank  first  reimburses  itself  for  the 
advance,  interest,  and  collection  charges,  and  then 
dehvers  the  balance  to  the  exporter. 

Credit  for  financing  a  foreign  transaction  is  also 
supplied  by  the  exporter's  bank  through  what  is  known 
as  a  refinancing  acceptance.  Under  this  method  the 
exporter  and  his  bank  enter  into  an  acceptance  agree- 
ment. In  accordance  with  the  terms  of  this  contract 
the  exporter  draws  his  draft  on  the  importer  and  sur- 
renders this  instrument,  together  with  the  accompany- 
ing documents,  to  his  bank,  which  forwards  them  for 
collection.  In  return  the  exporter  is  permitted  to 
draw  a  clean  time  draft  on  the  bank  which  accepts  it. 
The  instrument  then  becomes  a  banker's  acceptance 
which  the  exporter  may  sell  in  the  open  market. 

IV.  Financing  of  Foreign  Trade  by  the  Importer. 

In  foreign  trade  the  sellers  and  buyers  of  merchandise 
are  confronted  with  greater  risks  than  in  domestic 
commerce,  and  so  it  is  necessary  for  both  parties  to  take 
measures  for  the  protection  of  their  interests.  The 
exporter  desires  reimbursement  as  soon  as  he  releases 
his  goods,  while  the  importer  does  not  wish  to  make 
payment  until  he  is  sure  that  he  ^dll  receive  the  goods 
which  he  has  ordered.  These  ends  are  attained  by  the 
use  of  two  documents  known  as  the  "authority  to 
purchase"  and  the  ''letter  of  credit."  By  means  of 
these  instruments,  the  exporter  is  authorized  to  draw 
his  drafts  and  is  assured  that  they  will  be  honored, 
provided  he  deUvers  documents  evidencing  the  ship- 
ment of  the  goods  ordered  by  the  importer.  The  au- 
thority to  purchase  is  issued  by  one  bank  instructing  a 
second  bank  to  buy  the  drafts  drawn  by  the  beneficiary 


FINANCING  FOREIGN  TRADE      277 

on  the  importer,  and  thus  the  document  gives  rise  to  a 
trade  bill.  Ordinarily  it  could  not  well  be  sold,  especially 
if  drawn  on  a  foreign  firm  whose  credit  standing  is  little 
known,  but  this  difficulty  is  overcome,  since  the  bank 
agrees  with  the  exporter  to  buy  his  draft.  Because 
of  the  restricted  marketability  of  such  trade  bills,  the 
authority  to  purchase  is  not  used  extensively,  and  in 
fact  is  limited  to  the  financing  of  exports  to  the  Far 
East. 

The  letter  of  credit  has  widespread  application  in 
foreign  trade,  for  it  aids  the  shipment  of  goods  to  all 
parts  of  the  world.  The  letter  of  credit  differs  from 
the  authority  to  purchase  in  that  it  instructs  the  bene- 
ficiary to  draw  his  drafts  not  upon  the  importer,  but 
upon  a  bank,  thereby  substituting  its  better-known 
credit  for  the  limited  reputation  of  the  importer. 
The  use  of  the  letter  of  credit  may  be  illustrated  by 
tracing  the  financing  of  a  shipment  of  merchandise. 
The  American  Importing  Company  of  New  York  has 
ordered  £1,000  worth  of  cotton  goods  from  the  British 
Exporting  Company  of  London,  and  the  two  concerns 
have  entered  into  a  sales  contract  which  specifies  among 
other  conditions  that  the  importer  must  supply  a  bank- 
er's credit.  The  American  firm  thereupon  requests  a 
letter  of  credit  from  its  New  York  bank,  which  first 
investigates  the  applicant's  standing  with  the  same 
care  as  in  extending  a  loan.  If  his  credit  is  considered 
satisfactory,  the  bank  requests  him  to  sign  a  contract 
in  which  the  bank  agrees  to  issue  the  letter  of  credit 
on  behalf  of  the  importer,  who,  on  his  part,  promises 
to  pay  the  commission  for  this  service,  to  reimburse 
the  bank  for  all  outlays,  and  to  pledge  the  merchandise 
as  security. 

The  American  bank,  as  credit  issuer,  may  inform  the 
British  Exporting  Company  of  the  o])ening  of  the  credit 
by  delivering  the  letter  to  the  importer,  who  mails  it 


278  BANKING  AND   BUSINESS 

to  the  beneficiary.  The  American  bank  may  also  send 
its  London  correspondent  a  cable  stating  that  a  credit 
has  been  opened  in  favor  of  the  British  firm,  and  the 
London  bank  then  transmits  this  information  to  the 
exporting  company.  Whether  the  credit  is  received 
by  mail  or  by  cable,  the  recipient  immediately  prepares 
the  goods  for  export  and  forwards  them  to  the  sea- 
board, where  they  are  placed  on  a  vessel  for  New  York. 
The  exporting  company  then  draws  its  draft  upon  the 
American  credit-issuing  bank  and  presents  it  for  dis- 
count, together  with  shipping  documents,  to  a  British 
bank,  usually  the  same  one  which  has  advised  the 
credit.  The  documents  are  first  compared  with  the 
letter  of  credit,  and  if  the  terms  have  been  observed 
the  draft  is  discounted.  The  negotiator  then  sends 
both  draft  and  documents  to  its  New  York  correspond- 
ent, which  presents  them  to  the  credit-issuing  bank. 
If  it  is  a  demand  bill,  the  bank  pays  immediately,  and 
receives  reimbursement  from  the  importer  before  giv- 
ing him  the  shipment  documents  which  are  necessary 
for  him  to  secure  possession  of  the  goods  from  the 
carrier.  In  the  case  of  a  time  bill,  the  bank  accepts  it 
on  behalf  of  the  importer  and  gives  him  the  documents 
usually  after  he  has  signed  a  trust  receipt  acknowledg- 
ing that  he  is  holding  the  merchandise  merely  as  trustee 
for  the  bank.  The  importer  then  warehouses  the  mate- 
rial and  later  sells  it  to  some  one  else,  and  the  proceeds 
are  delivered  in  an  amount  sufficient  to  place  the  bank 
in  funds  to  cover  the  acceptances  usually  a  day  before 
their  maturity. 

As  indicated  in  the  above  illustration,  a  letter  of 
credit  is  the  authorization  addressed  to  the  beneficiary 
by  the  credit-issuing  bank,  under  which  the  former  is 
instructed  to  draw  drafts  up  to  a  specified  sum  and 
within  a  definite  time  upon  the  latter,  which  undertakes 
to  honor  the  drafts  if  they  are  accompanied  by  certain 


FINANCING   FOREIGN  TRADE      279 

documents.  As  this  instrument  in  foreign  trade  is 
addressed  by  a  bank  to  a  seller  located  abroad,  it  is 
sometimes  described  as  an  "import"  letter  of  credit. 
Where  the  information  is  transmitted  through  another 
bank  in  the  same  country  as  the  beneficiary,  the  advice 
is  called  an  "export"  letter  of  credit. 

V.  Classification  of  Letters  of  Credit. 

Letters  of  credit  may  also  be  classified,  according  to 
whether  the  issuing  bank  may  or  may  not  rescind 
its  obligation  to  the  beneficiary.  When  a  bank  agrees 
to  honor  the  drafts  of  the  exporter  within  a  certain 
period  of  time  the  instrument  is  called  an  irrc\'ocable 
letter  of  credit,  while  a  revocable  credit  may  be  canceled 
at  any  time  by  the  bank.  Letters  of  credit  are  fre- 
quently transmitted  to  the  beneficiary  not  directly 
by  the  issuing  bank,  but  indirectly  through  a  second 
notifying  bank.  If  the  latter  institution  adds  its 
guaranty  to  the  ol)ligation  of  the  former,  the  letter  of 
credit  is  then  said  to  be  confinned,  othe^^^'ise  it  is 
considered  unconfirmed.  Banks  may  therefore  gi\'e 
beneficiaries  the  following  kinds  of  credits:  (1)  irrevo- 
cable by  issuer  and  confirmed  by  notifier,  (2)  irrevocable 
by  issuer  and  unconfirmed  by  notifier,  (3)  revocable  by 
issuer  and  unconfirmed  by  notifier.  A  revocable 
confirmed  letter  of  credit  is  of  course  impossible  in 
actual  practice,  for  a  notifying  bank  would  untler  no 
condition  add  its  confirmation  to  an  instrument  which 
could  be  nullified  by  the  issuer  at  will. 

Letters  of  credit  may  also  be  grouped  according  to 
the  currency  in  which  they  are  issued.  Before  the  war 
the  letter  of  credit  drawn  in  sterling  was  the  standard  in- 
strument of  international  commerce,  but  in  recent  years 
the  dollar  credit  has  been  growing  in  fa\'or,  not  alone 
among  American  merchants,  but  also  with  foreign  firms. 


280  BANKING  AND   BUSINESS 

VI .  Traveler's  Letter  of  Credit. 

The  instrument  of  commerce  described  above  is  fre- 
quently confused  with  the  traveler's  letter  of  credit. 
These  two  documents  differ  as  to  purpose,  form,  and 
classification.  The  former  is  used  to  facilitate  the 
movement  of  goods,  while  the  latter  serves  as  a  means 
of  paying  the  expenses  of  a  person  who  is  journeying 
from  one  country  to  another.  The  commercial  letter 
of  credit  is  addressed  by  the  issuing  bank  to  the  bene- 
ficiary, who  is  authorized  to  draw  his  drafts,  while  the 
traveler's  letter  is  addressed  by  an  issuing  bank  to 
another  institution,  which  is  requested  to  honor  the 
demand  drafts  drawn  by  the  traveler  on  the  issuer  up 
to  a  specified  amount  and  before  a  fixed  date.  A  bank 
usually  issues  a  traveler's  letter  of  credit  upon  payment 
of  the  full  amount  by  the  beneficiary,  in  advance,  or  it 
may  receive  reimbursement  only  as  each  outlay  is 
made  by  the  traveler.  As  noted  above,  commercial 
letters  of  credit  were  classified  fundamentally  on  a  basis 
of  whether  or  not  they  can  be  canceled  without  the 
consent  of  the  beneficiary.  This  question  never  enters 
into  the  issuing  of  a  traveler's  credit.  The  document 
is  classified  rather  according  to  the  number  of  banks 
which  are  requested  to  act  as  payers.  The  traveler's 
letter  of  credit  may  be  addressed  to  only  one  bank,  and 
it  is  then  said  to  be  a  specially  advised  form.  As  trav- 
eler's letters  of  credit  are  frequently  lost,  this  type  has 
the  advantages  of  being  easily  canceled  and  of  stopping 
further  payment  of  drafts  drawn  by  persons  other  than 
the  proper  beneficiary.  The  circular,  or  general  letter 
of  credit  gives  the  traveler  the  right  to  negotiate  his 
bills  with  a  number  of  correspondents,  which  are 
at  times  listed  on  the  letter  of  credit.  Traveler's  credits 
are  drawn  in  dollars,  pounds,  francs,  or  any  other  cur- 
rencies desired  by  the  beneficiary. 


FINANCING   FOREIGN   TRADE      281 

The  traveler's  letter  of  credit  is  of  advantage  to  all 
parties  concerned.  The  traveler  is  furnished  with  the 
current  funds  for  his  journey,  thus  eliminating  the  risk  of 
carrying  a  supply  of  cash,  and  at  the  same  time  the  letter 
also  serves  as  a  dignified  introduction  from  his  bank. 
This  institution  collects  a  commission  on  the  total 
amount,  and  also  has  use  of  the  funds  until  they  are 
actually  expended  by  the  traveler.  The  foreign  corre- 
spondent bank  which  negotiates  the  drafts  usually  buys 
them  at  a  rate  lower  than  the  market  price,  and  thus 
gains  a  profit  on  the  exchange. 

VII.  The  Organization  of  a  Foreign  Department. 

In  this  survey  of  international  banking,  its  similarity 
to  and  its  difference  from  domestic  practice  has  been 
surveyed,  and  now  the  special  features  in  the  organiza- 
tion of  a  foreign  department  will  be  indicated.  This 
department  is  usually  organized  under  the  following 
divisions:  (1)  exchange  (engaged  in  buying  and  selling 
foreign  bills);  (2)  loan  and  discount  (grants  advances 
on  foreign  bills  or  buys  them  outright);  (3)  collection 
(forwards  to  foreign  correspondents  for  payment  all 
bills  purchased  by  the  bank  or  received  from  custom- 
ers for  collection) ;  (4)  commercial  credit  (opens  im- 
port and  export  letters  of  credit). 

VIII.  Development  of  American  Banks  Financing 

Foreign  Trade. 

For  many  years  these  services  could  be  secured  by 
American  exporters  and  importers  from  foreign  banks 
with  New  York  agencies  only  or  from  a  small  number 
of  private  banks.  In  recent  years,  however,  large 
national  banks  and  trust  companies  have  opened  for- 
eign departments  and  have  thus  materially  aided  the 
expansion  of  our  foreign  trade. 


282  BANKING  AND   BUSINESS 

It  was  necessary  for  these  institutions  to  establish 
close  relations  with  important  money  centers  through- 
out the  world.  Such  associations  were  secured  in  the 
past  by  employing  the  services  of  foreign  banks  as 
correspondents.  This  plan  was  followed  by  many 
American  banks  because  of  their  own  inexperience  and 
lack  of  credit  information.  The  necessary  connections 
with  foreign-exchange  markets  are  also  attained  by 
establishing  branches.  As  practically  all  the  American 
banks  interested  in  foreign  trade  have  been  located  in 
New  York,  this  state  was  the  first  to  authorize  the 
operation  of  branches  abroad.  Accordingly,  several 
trust  companies  opened  offices  in  London  and  on  the 
Continent.  This  power  was  denied  to  national  banks 
until  1916,  when  an  amendment  to  the  Federal  Reserve 
Act  permitted  institutions  with  a  capital  and  sm-plus 
of  over  $1,000,000  to  establish  foreign  branches,  but 
this  privilege  was  exercised  by  only  two  banks. 

Meantime,  American  banks  tended  to  expand  their 
international  relations  not  through  the  opening  of 
branches,  but  through  the  organization  of  overseas 
banks  engaged  exclusively  in  foreign  trade.  Under  the 
laws  of  New  York  State,  banking  institutions  were  per- 
mitted to  hold  stock  in  corporations  financing  foreign 
trade,  and  accordingly  a  number  of  them  have  been 
founded.  These  international  houses  perform  all  bank- 
ing operations,  but  have  generally  limited  their  activi- 
ties to  the  Far  East  and  to  South  America.  In  1916 
the  Federal  Reserve  Act  likewise  empowered  national 
banks  with  a  combined  capital  and  surplus  of  over 
$1,000,000  to  invest  10  per  cent  in  the  stock  of  foreign 
banking  corporations,  whether  organized  under  the  laws 
of  the  state  or  those  of  the  federal  government.  These 
provisions  were  further  extended  in  1919  by  the  jMcLean 
Act,  which  permitted  any  national  bank,  regardless  of 
its  size,  to  invest  5  per  cent  of  its  capital  and  surplus 


FINANCING   FOREIGN   TRADE      283 

in  the  stock  of  a  foreign  banking  corporation.  But  as 
a  matter  of  fact  Congress  had  never  made  provision 
for  the  organization  of  overseas  banks  under  national 
law.  The  need  of  further  legislation  was  accentuated 
by  our  unbalanced  trade,  which  continued  even  after 
the  annistice.  During  the  war  the  movement  of  goods 
in  international  trade  had  been  financed  largely  through 
the  extension  of  government  credit,  and  upon  its  with- 
drawal American  banks  found  difficulty  in  furnishing 
credit  sufficient  in  amount  and  in  maturity  to  meet 
the  needs  of  foreign  buyers. 

For  these  reasons,  Congress  in  1919  passed  the  Edge 
Act.  This  statute  seeks  primarily  to  provide  long-term 
credit  for  foreign  purchasers  of  American  exports. 
To  attain  this  end  the  statute  authorizes  the  organiza- 
tion of  corporations  with  capital  stock  of  not  less 
than  $2,000,000  and  under  the  supervision  of  the 
Federal  Reserve  Board. 

In  accordance  with  the  regulations  of  the  board,  two 
types  of  Edge-law  corporations  have  been  organized. 
One  form  is  a  commercial  bank  empowered  to  create 
acceptances  based  on  exports  to  foreign  countries  and 
to  operate  branches  abroad.  The  second  type  is  rather 
an  investment  bank.  It  is  not  permitted  to  make 
acceptances  or  conduct  branches,  but  is  given  full 
power  to  issue  and  sell  its  own  debentures.  These 
obligations  may  be  based  on  two  classes  of  collateral 
held  in  trust:  (1)  commercial  paper  of  a  self-liquidat- 
ing nature,  (2)  foreign  securities. 

The  American  Bankers'  Association  projected  in  1921 
a  large  Edge  corporation  and  offered  S100,000,000  of 
stock  for  the  purpose  of  purchasing  high-grade  foreign 
securities  and  using  them  as  collateral  to  protect  its  own 
debentures.  The  object  was  to  .sell  the  obligations  of 
an  American  corporation  to  the  investing  public,  whicli 
might  be  unwilling  to  absorb  foreign  securities  directly. 


284  BANKING  AND   BUSINESS 

In  this  way  the  unbalanced  trade  between  the  United 
States  and  the  rest  of  the  world,  which  can  be  corrected 
neither  by  the  shipment  of  gold  because  of  its  insuf- 
ficient amount,  nor  by  the  importation  of  merchandise 
because  of  its  reaction  on  American  industry,  would 
be  stabilized  by  the  export  of  capital  from  the  United 
States  through  foreign  investments.  The  future  of 
foreign  trade  financing  is  still  uncertain. 


CHAPTER  XVIII 

BANKING   METHODS  IN   FOREIGN  COUNTRIES 

I.  Difference  in  Relationships  Between  Busi- 
ness AND  Banking  in  the  United  States  and 
Great  Britain. 

While  banking  methods  are  in  their  essential  nature 
the  same  in  all  countries,  there  are  differences  of  detail 
which  exist  as  between  the  principal  commercial  na- 
tions, and  which  must  be  understood  by  those  who  are 
either  familiarizing  themselves  with  banking  methods 
in  general  or  who  have  business  to  transact  with  foreign 
countries.  It  would  be  impossible  to  furnish  in  great 
detail  the  points  at  which  variations  of  practice  exist. 
Some  of  the  chief  lines  of  difference  must,  however, 
be  set  forth.  In  what  is  here  said  it  must  be  remem- 
bered that  ''foreign"  methods  are  by  no  means  uniform, 
but  that  the  various  foreign  countries  differ  much 
among  themselves,  while  on  the  other  hand  business 
practice  is  itself  unstable  and  changes  from  time  to 
time,  so  that  only  broad  generalizations  can  be  made. 

Perhaps  the  most  striking  difference  in  the  relation- 
ship between  the  business  man  and  the  bank  is  noted 
when  comparison  is  made  between  American  practice 
and  the  practice  which  prevails  in  Great  Britain  and 
other  English-speaking  countries.  TMiereas  an  Ameri- 
can establishment  may,  and  indeed  usually  does,  main- 
tain several  bank  accounts,  borrowing  from  a  variety 
of  banks  and  at  times  also  selling  paper  in  the  open 
market,  the  British  business  man  feels  constrained  to 
confine  himself  ordinarily  to  one  or,   under  unusual 


286  BANKING  AND  BUSINESS 

conditions,  two  banking  establishments.  There  is  an 
important  apphcation  of  theory  which  underUes  this 
difference  in  practice.  Foreign  and  especially  British 
banks  hold  to  the  view  that  there  is  a  close  affiliation 
between  the  business  establishment  and  the  bank,  and 
that  the  bank  should  be  prepared  to  sustain  and 
support  the  business  establishment  in  all  legitimate 
operations  which  fall  within  its  general  scope.  In  these 
circumstances  it  has  a  right  to  know  intimately  the  con- 
dition of  the  business  and  to  keep  a  constant  check  upon 
the  uses  made  by  the  business  house  of  its  funds.  This 
is  hardly  practicable  where  the  business  establishment 
deals  with  many  banks.  On  the  other  hand,  the  lower 
degree  of  publicity  with  respect  to  bank  accounts 
which  exists  in  England  and  in  English  colonies  would 
practically  prevent  the  bank  from  keeping  as  close 
touch  mth  the  affairs  of  the  individual  business  house 
as  it  could  were  that  house  to  deal  with  it  and  with  it 
alone.  The  branch  system  of  banking,  which  prevails 
in  most  foreign  countries  but  is  not  permitted  under 
the  banking  laws  of  the  United  States,  renders  this 
close  relationship  between  the  bank  and  the  business 
house  feasible.  It  certainly  could  not  exist  in  that 
form  in  any  country  where  the  business  establishment 
maintained  many  offices  or  branches  and  the  bank  had 
but  one  office.  The  different  character  of  the  relation- 
ship which  thus  exists  between  business  and  banking 
in  the  United  States  and  in  other  countries  furnishes  an 
influence  which  ramifies  broadly  into  many  fields  and 
produces  alterations  of  practice  that  are  often  regarded 
as  merely  accidental,  notwithstanding  they  grow  out 
of  the  condition  just  described. 

II.  Comparison  of  Methods  of  Financing  Business. 
Partly  as  a  result  of  the  different  relationships  exist- 
ing between  the  business  and  the  bank  as  thus  set  forth, 


FOREIGN  BANKING   METHODS     287 

there  is  to  be  noted  a  peculiarity  in  the  method  of 
financing  industry  which  lias  taken  root  in  the  United 
States.  In  this  country  it  has  become  more  and  more 
the  practice  for  the  manufacturer,  or,  iji  some  hnes, 
the  wholesaler  or  jobber,  to  finance  the  retailer,  while 
the  retailer  finances  the  customer.  This  situation  is 
seen  in  most  extreme  form  in  the  sale  of  goods  upon  the 
installment  plan.  The  manufacturer  of  farm  machinery 
or  pianos,  let  us  say,  sells  his  product  to  a  jobber  or 
distributor,  who  gives  a  note  or  acceptance  for  the 
amount  due  at  a  maturity  which  varies  from  trade  to 
trade.  The  distributor  then,  either  through  a  retailer 
or  perhaps  in  direct  sale  to  the  customer,  disposes  of  the 
goods  which  he  has  thus  taken  on.  He  allows  the  con- 
sumer to  pay  for  them  at  so  much  a  month  over  a 
period  of,  say,  tweh'e  months.  It  is  clear  that  in  this 
case  the  merchant  who  sells  the  machinery  or  pianos 
to  the  purchaser  has  to  provide  the  capital  for  carrying 
them  during  the  period  of  payment.  This  he  can  do 
if  the  manufacturer's  claims  upon  him  run  for  an  etiual 
length  of  time.  In  that  event  the  real  burden  of  financ- 
ing the  whole  series  of  transactions  may  be  transferred 
to  the  manufacturer's  banker  through  the  applications 
of  the  manufacturer  to  him  for  funds  with  which  to 
carry  his  operations  during  the  months  between  the 
selhng  date  and  the  date  of  payment. 

In  foreign  countries,  although  the  American  method 
of  financing  at  the  source  has  made  progress  of  recent 
years,  the  older  plan  was  that  of  tloing  the  financing 
at  the  point  of  distribution.  The  manufacturer  sold 
to  the  distributor  on  a  short-term  credit  basis,  and  the 
distributor,  if  he  needed  funds,  got  them  from  the 
local  bank.  The  credit  he  extended  to  the  consumer 
was  shorter,  or  in  some  cases  the  consiniicr  might  be 
requested  to  give  paper  for  anything  more  than  a  very 
small  current  open  account  representing  daily  supplies. 


288  BANKING  AND   BUSINESS 

This  difference  in  financing  was  not  so  significant  in 
foreign  countries  as  it  is  in  the  United  States,  because 
the  lending  of  funds  to  the  retailer  or  distributor  was 
then  often  done  by  a  branch  of  the  parent  bank  whose 
head  office  perhaps  was  situated  at  the  point  of  manu- 
facture. Still,  the  difference  was  of  very  considerable 
importance  from  the  technical  standpoint. 

III.  Chakactek  of  Paper. 

Growing  out  of  this  difference  in  practice  regarding 
the  location  of  financing  there  has  been  of  late  years  a 
distinct  difference  of  practice  with  respect  to  the 
character  of  the  paper  by  which  loans  were  represented. 
In  the  United  States  the  predominant  type  of  bank 
loans  is  the  ''straight  single-name  note"  already  de- 
scribed and  illustrated  (see  page  110).  This  note,  as 
already  explained,  may  be  either  secured  or  unsecured. 
In  the  same  way  under  the  classical  foreign  practice 
the  predominant  type  of  bank  paper  was  the  accept- 
ance, as  already  explained  and  illustrated  (see  page  30). 
As  has  been  seen,  there  is  no  difference  in  the  charact^er 
of  the  obligation  incurred  by  the  maker  of  a  note  and 
the  acceptor  of  a  draft.  The  two  types  of  financing 
may,  however,  lead  to  somewhat  different  results.  In 
the  older  British  practice  the  acceptance  was  drawn  to 
represent  a  shipment  of  goods.  The  goods  accom- 
panied the  draft  or  perhaps  followed  it  within  a  short 
time.  In  the  United  States  the  single-name  note  may 
or  may  not  represent  a  shipment  of  goods.  In  its  best 
form  it  represents  a  lump  sum  of  bank  funds  or  "ac- 
conamodation "  which  does  not  exceed  the  power  of  the 
business  at  any  time  to  pay  out  of  its  "Hquid"  assets. 
In  American  practice,  such  an  advance  may  be  used 
for  any  purpose;  the  test  of  banking  \\isdom  or  pru- 
dence being  found  in  keeping  the  total  amount  of  such 
advances  or  loans  down  to  the  proper  figure.     It  is 


FOREIGN   BANKING  METHODS     289 

true  that  in  Great  Britain  and  some  other  countries 
there  has  of  recent  years  been  an  increasing  practice 
of  lending  on  "overdraft  account"  which  represents 
exactly  the  same  banking  idea  as  our  own  unsecured 
straight  note,  the  chief  technical  difference  being  found 
in  the  fact  that  whereas  American  practice  retiuires 
the  making  of  an  actual  note,  foreign  overdraft  practice 
merely  enters  a  book  charge  against  the  customer. 

IV.  Credit  Study. 

The  American  single-name-note  and  cash-discount 
method  of  lending,  however  (and  for  that  matter  the 
overdraft  plan  in  so  far  as  adopted),  necessitates  a 
special  type  of  credit  study.  Since  the  goods  do  not 
accompany  the  draft  or  note,  thus  evidencing  an  actual 
sale,  the  superficial  test  of  liquidating  power  which  is 
thereby  furnished  disappears.  It  is  necessary  to  obtain 
a  test  of  liquidating  power  from  some  other  sources, 
and  this  can  be  done  by  making  a  careful  analysis  of 
the  business  establishment  from  the  crecUt  standpoint. 
Hence  the  growth  of  credit-analysis  departments  in 
American  banks  upon  a  scale  considerably  superior  to 
that  which  exists  in  many  foreign  countries.  The  pur- 
pose of  American  credit-analj^sis  is  to  ascertain  the 
conditions  under  which  a  business  is  operating,  the 
probable  amount  of  its  reciuirements,  the  sums  which 
it  can  be  expected  to  pay  readily  out  of  ciurent  ojiera- 
tions,  and,  as  a  corollary  from  these  items  of  informa- 
tion, the  conclusion  whether  advances  that  have  been 
applied  for  ought  to  be  granted  or  not.  This  tj'pe  of 
credit  analysis  is  at  times  scientific  in  the  highest  degree, 
and  when  accompanied  by  the  best  equality  of  banking 
prudence  and  judgment  undoubtetlly  gi\'es  rise  to  a 
higher  type  of  banking  loan  than  that  which  has  pre- 
vailed in  most  foreign  countries.  The  expressed 
opinion  of  some   leading  American   bankers   is   that 


290  BANKING   AND   BUSINESS 

"prime"  single-name  notes  of  the  best  American 
business  houses  are  probably  the  best  type  of  com- 
mercial paper  in  existence — certainly  not  exceeded  even 
by  the  "prime"  acceptances  of  foreign  countries. 
At  all  events,  the  difference  in  the  method  of  lending 
has  important  results  which  are  reflected  in  business, 
and  the  distinction  which  has  been  drawn  between  our 
own  and  foreign  practice  is  therefore  worthy  of  careful 
study. 

V.  Method  of  Credit  Extension. 

Foreign  banking  methods  differ  from  American  not 
only  in  the  matter  of  technic  and  in  the  relationship 
which  exists  between  the  individual  and  his  bank,  but 
also  from  the  standpoint  of  internal  banking  manage- 
ment, as  well  as  from  that  of  general  credit  extension. 
On  the  latter  point  the  differences  of  practice  and 
method  are  rather  important.  In  a  general  way  there 
are,  as  the  reader  is  aware,  two  important  methods  by 
which  banks  extend  credit — the  one  the  issue  of  notes, 
the  other  the  creation  of  credit  deposits  which  are 
drawn  upon  at  the  pleasure  of  the  borrower.  In  the 
United  States  the  latter  method  of  extending  credit 
has  become  almost  preponderant.  There  are  large 
issues  of  bank  notes,  of  course,  and  in  some  parts  of  the 
country  they  have  a  function  of  extreme  importance 
to  perform.  But  it  may  fairly  be  said  that  the  banking 
development  of  the  past  fifty  years  in  the  United  States 
has  been  ahnost  wholly  along  the  hne  of  the  deposit, 
and  that  the  note  has.  played  a  more  and  more  subordi- 
nate part  as  time  has  gone  on.  Very  much  the  same  is 
true  of  Great  Britain,  and  for  somewhat  the  same 
reasons.  When  w^e  turn  to  continental  banking,  how- 
ever, it  is  observable  that  the  main  line  of  development 
has  been  in  a  somewhat  different  direction.  In  France, 
for  example,   the  central  bank,   while  carrying  large 


FOREIGN   BANKING   METHODS      291 

lines  of  deposits,  has  granted  the  preponderating  part 
of  its  accommodation  in  the  form  of  notes.  Other 
banks  have  then  taken  these  notes  and  held  them  in 
their  vaults  as  reserves,  while  business  men,  instead  of 
checking  as  freely  upon  banking  accounts  as  do  Ameri- 
can business  men,  have  been  more  in  the  habit  of  keep- 
ing the  notes  in  a  safe  or  strong  box  out  of  which  they 
would  be  paid  as  occasion  required.  The  distinction 
between  the  two  types  of  banking  may  be  strongly 
emphasized  by  contrasting  a  statement  of  the  Second 
Bank  of  the  United  States,  which  terminated  its  career 
in  1837,  with  the  statement  of,  say,  one  of  the  large 
New  York  banks  for  the  year  1920. 

From  such  comparison  it  is  obvious  that  the  bulk  of 
the  loans  made  by  the  Second  Bank  of  the  United 
States  must  have  been  made  in  the  form  of  notes,  while 
the  New  York  bank  could  not  have  done  much  business 
had  it  been  hmited  to  its  note  habihty.  A  similar  com- 
parison might  be  drawn  between  one  of  the  London 
joint-stock  banks  to-day  and  the  same  institution  fifty 
or  sixty  years  ago.  This  distinction  is  of  a  good  deal 
more  than  merely  technical  importance.  It  is  founded 
upon  the  different  business  habits  or  practices  which 
grow  out  of  the  fact  that  in  some  countries  actual 
money  or  a  substitute  for  it  is  wanted  in  business,  while 
elsewhere  the  check-and-deposit  system  is  more  ac- 
ceptable. Under  the  two  systems  very  considerable 
differences  in  practice  naturally  arise. 

It  is  not  necessaiy  to  go  into  these  differences  at  this 
point,  and  it  need  only  be  said  that  in  the  main  the 
check-and-deposit  system,  as  exemplified  in  American 
banking,  is  one  which  minimizes  the  use  of  cash  and 
results  in  the  clearing  of  a  very  large  amount  of  obli- 
gations without  any  emplopnent  either  of  money  or 
of  money  substitutes,  but  that  this  system  has  a  tend- 
ency to  instability,  due  to  the  fact  that  its  basis  may 


292  BANKING  AND   BUSINESS 

be  rapidly  weakened  by  the  export  of  coin  or  by  the 
withdrawal  of  it  from  banks.  Conversely,  inflation  is 
more  easily  produced  through  the  sudden  growth  of 
bank  deposits.  In  the  countries  which  have  developed 
along  the  note  or  circulation  line  of  growth  large  quan- 
tities of  currency  are  held  in  circulation.  A  given 
amount  of  them  is  practically  necessary  at  all  times  in 
order  to  do  the  business  of  the  country.  The  central 
note-issuing  bank  is  thus  performing  a  quasi-pubUc 
function  in  supplying  notes,  and  the  stability  of  the 
system  is  greater  because  the  needs  of  the  community 
for  the  notes  and  currency  are  such  that  they  tend  to 
keep  a  given  volume  of  them  in  circulation  constantly. 
This  is  true  even  where  the  redemption  is  quite  rapid — 
that  is  to  say,  where  the  whole  volume  of  notes  is 
redeemed  by  the  issuing  bank  within  a  very  short 
time. 

Such  rapidity  of  contraction  is  called  elasticity  when 
it  is  accompanied  by  correspondingly  easy  expansion. 
It  has  Uttle  to  do  with  the  amount  of  notes  held  in  the 
circulation  at  any  given  time.  This  difference  of  prac- 
tice as  between  continental  countries,  on  the  one  hand, 
and  England  and  the  United  States,  on  the  other,  also 
implies  great  difference  of  practice  in  remittances  and 
collections  and  tends  to  produce  a  quite  different  ideal 
of  the  banking  situation.  A  credit  deposit  plan  is 
practically  necessary  to  business  as  it  is  organized  in 
the  United  States.  Across  the  Canadian  border,  where 
industry  is  organized  on  a  rather  more  primitive  basis 
and  under  the  branch-bank  system  already  described 
in  this  volume,  there  is  a  much  greater  reliance  upon 
notes  and  relatively  smaller  use  of  checks,  notwith- 
standing that  the  number  of  banking  offices  in  Canada 
is  very  large.  In  general  the  note  finds  its  best  function 
in  the  community  which  is  not  much  accustomed  to 
checking  and  is  not  encouraged  to  resort  to  banks, 


FOREIGN   BANKING  METHODS     293 

while  those  countries  which  have  made  banking  simple 
and  easy  of  access  usually  find  that  customei*s 
promptly  give  up  the  use  of  notes  and  substitute  credit 
instruments  in  heu  thereof. 

VI.  Foreign  and  Domestic  Trade  Financing. 

A  further  distinction  between  American  and  foreign 
banking  methods  is  seen  in  the  different  emphasis  which 
is  placed,  respectively,  upon  domestic  and  foreign  trade 
in  foreign  countries.  In  the  United  States,  foreign 
trade  operations  have  been  given  a  very  special  place 
of  their  own,  and  the  emphasis  has  been  laid  almost 
entirely  upon  domestic  banking  and  its  development. 
In  Europe,  almost  exactly  the  reverse  of  this  situation 
exists.  The  distinction  is  due  to  the  difference  in  the 
size  of  the  countries  and  to  the  character  of  their 
financial  development. 

VII.  Personnel. 

One  other  element  in  foreign  methods  which  dis- 
tinctly differentiates  them  from  those  of  the  United 
States  is  seen  in  the  fact  that  in  Europe  banking  has 
become  a  highly  professionalized  occupation.  In  the 
United  States  it  has  until  recently  been  looked  upon 
rather  as  a  business.  The  distinction  may  seem  at 
first  sight  to  be  one  of  secondary  importance  or  an 
observation  which  is  of  interest  rather  from  the  broad 
general  standpoint  than  from  the  point  of  view  of 
actual  organization  of  banking.  It,  however,  relates 
to  a  condition  of  affairs  which  is  of  considerably  more 
inclusive  character  than  would  thus  be  suggested. 
The  banking  personnel  of  the  United  Stat.es  is  recruited 
after  methods  running  very  closely  parallel  to  those 
which  obtain  in  connection  with  its  banking  organiza- 
tion. As  has  elsewhere  been  seen,  however,  in  Euro- 
pean countries — indeed,  in  almost  all  foreign  countries 


294  BANKING   AND   BUSINESS 

— the  establishment  of  a  new  bank  is  looked  upon  as 
an  undertaldng  of  very  great  moment  to  the  com- 
munity and  as  deserving  in  some  countries  of  special 
authorization  by  the  legislature,  while  in  others  it  is 
so  surrounded  wdth  difficulties  of  one  sort  or  another 
that  the  number  of  banks  increases  very  slowly.  In 
the  United  States,  as  we  have  seen,  however,  the  object 
of  the  law  has  been  that  of  encouraging  the  growth  of 
small  banks.  This  is  reflected  in  the  fact  that  a  single 
year  may  see  the  organization  of  hundreds  of  such 
institutions.  In  the  national  banking  system  alone  the 
number  of  banks  organized  during  the  year  1920  was 
about  300.  If  the  number  organized  under  state  laws 
were  to  be  added,  the  total  figure  would  probably  come 
to  double  that  which  has  just  been  given.  It  need 
hardly  be  said  that  with  so  many  banks  coming  into 
existence  it  is  difficult  to  obtain  a  trained  and  well- 
equipped  personnel. 

The  personnel  is,  therefore,  recruited  for  the  most 
part  from  commercial  businesses.  A  few  employees  of 
the  older  banks  are  engaged  to  train  the  personnel  of 
the  new  institution.  The  result  is  to  establish  in  many 
banks  a  rather  unsatisfactory  and  unprofessional  style 
of  management.  Accounting  and  bookkeeping  methods 
are  by  no  means  uniform,  and  while  much  has  been 
done  by  the  Comptroller  of  the  Currency  and  the  sev- 
eral superintendents  of  banking  to  introduce  uniformity 
of  practice  by  enforcing  the  laws  as  to  maintenance  of 
reserves  on  hand,  of  paper  discounted,  and  the  hke, 
such  efforts  have  been  successful  only  in  a  rather  vague 
way.  It  is  almost  necessarily  true  that  great  differences 
of  practice  and  great  differences  in  character  of  per- 
sonnel obtain  between  one  of  the  larger  city  banks 
and  the  bank  of  $25,000  capital  in  the  South  and 
West. 

The  state  of  things  thus  indicated  is  naturally  cor 


FOREIGN   BANKING   METHODS     295 

relative  with  a  condition  in  which  promotion  is  by  no 
means  steady  or  assured.  Employees  of  capacity  and 
abihty  usually  make  their  way  in  all  institutions,  but 
the  rank  and  file  of  the  personnel  of  the  ordinary  bank 
may  or  may  not  be  steadily  ad\'anced  as  experience 
and  training  seem  to  warrant,  and  in  any  case  may 
find  it  hard  to  get  outside  their  local  community.  The 
outcome  of  this  is  a  rather  rapid  transference  of  em- 
ployees from  banking  institutions  to  business  houses, 
followed,  of  course,  by  the  recruiting  of  bank  staffs 
from  outside  employment  as  circumstances  demand  or 
require.  Wliile  there  is  some  interchange  of  banking 
employees  between  institutions  of  different  cities,  the 
amount  of  it  is  relatively  small.  An  able  officer  of  a 
country  bank  is  Ukely  to  be  a  man  of  distinction  in  his 
community,  and  eventually  may  receive  an  offer  from 
an  institution  in  some  city,  neighboring  or  otherwise, 
which  gives  him  a  larger  field  for  his  activity. 

It  often  happens,  however,  that  such  openings  come 
to  bankers  on  the  strength  of  their  business-getting 
capacity  rather  than  on  the  basis  of  skill  and  quick 
judgment  in  the  management  of  banking  affairs.  So 
much  may  be  noted  by  way  of  background  for  a  brief 
sketch  of  foreign  practice.  In  the  large  foreign  bank 
with  many  branches  the  endeavor  is  made  to  establish 
a  regular  basis  of  promotion  so  that  men  are  advanced 
from  grade  to  grade  with  corresponding  increases  of 
salary  as  their  merits  seem  to  require.  This  is  rendered 
possible  by  the  existence  of  the  branch  system,  which 
permits  constant  training  in  management  and  gives 
opportunity  for  the  testing  of  capable  members  of  the 
banking  staff  by  placing  them  in  charge  of  independent 
offices  where  they  are  able  to  show  their  ability. 
Entrance  into  a  banking  staff  thus  means  entrance  into 
a  professional  occupation  which  holds  out  a  definite 
career  for  the  future,  and  in  which  advancement,  while 

20 


296  BANKING  AND   BUSINESS 

not  rapid  and  often  not  very  remunerative,  is  com- 
paratively certain.  The  result  of  this  method  of 
organization  is  to  establish  a  much  more  rigid  standard 
of  professional  conduct,  or  ethics,  in  banking  than 
that  which  exists  in  the  United  States,  where,  as  already 
remarked,  banking  is  still  for  the  most  part  on  a  basis 
of  business  rather  than  of  professional  ethics.  There 
is  a  much  smaller  amount  of  shifting  between  banking 
staffs  and  those  of  business  houses  in  such  a  country 
as  England  than  there  is  in  the  United  States,  and  a 
greater  disposition  on  the  part  of  business  houses  to 
follow  the  advice  of  the  banks  with  which  they  deal 
than  there  is  in  this  country. 


Part   III 
NONCOMMERCIAL  BANKING 


CHAPTER  XIX 

THE   INVESTMENT   BANK 

Consideration  has  thus  far  been  given  mainly  to 
the  various  aspects  of  commercial  banking  which  sup- 
pUes  business  men  with  short-term  credit  to  meet  their 
current  needs.  Reference  has  occasionally  been  made 
to  investment  or  long-term  credit  which  furnishes  funds 
for  pennanent  economic  improvements  through  such 
instruments  as  stocks,  bonds,  and  notes.  The  follow- 
ing three  chapters  will  present  the  essentials  of  invest- 
ment banks,  as  well  as  savings  banks  and  trust  com- 
panies which  may  also  be  regarded  as  investment 
institutions. 

I.  Development  of  the  Investment  Bank. 

Investment  bankers  originated  in  the  Middle  Ages, 
when  governments  and  kings  received  long-term  loans 
for  conducting  wars  and  maintaining  courts.  Notable 
among  the  early  money  lenders  were  the  Hansa  mer- 
chants who  supplied  funds  to  many  of  the  European 
kings  and  emperors,  but  usually  with  assurance  of 
return.  The  ruler  received  a  certain  sum  of  money 
in  the  form  of  gold  or  silver  bullion,  and  in  return  he 
gave  the  lender  the  rights  over  revenue  derived  from 
tariffs  or  taxes  for  a  certain  period  of  years.  Loans 
were  also  extended  on  real  property  such  as  mines, 
fisheries,  and  forests  owned  by  the  government,  and 
the  products  of  the  mines  were  applied  to  the  pajnient 
of  principal  and  interest.    These  early  magnates  were 


300  BANKING  AND   BUSINESS 

also  merchants,  and  they  were  able  to  use  their  own 
money  directly  in  granting  loans,  and  in  this  way  they 
differed  from  the  modern  investment  bankers  who  act 
as  intermediaries  in  gathering  the  funds  of  others  for 
making  advances  to  borrowers.  With  the  close  of  the 
Napoleonic  wars  financial  supremacy  shifted  from 
Amsterdam  and  the  Continent  to  London,  and  with 
this  change  the  modern  investment  bank  as  an  inter- 
mediary institution  between  borrower  and  lender  was 
developed. 

The  same  general  evolution  was  repeated  in  the 
financial  history  of  the  United  States.  During  the  first 
quarter  of  the  nineteenth  century  American  states  and 
municipalities  secured  whatever  capital  they  needed 
from  merchants.  During  the  second  quarter,  the  west- 
ward movement  caused  an  extension  of  such  internal 
improvements  as  canals  and  railroads,  and  capital 
for  these  purposes  was  raised  mainly  from  investors  in 
England  and  in  other  European  countries.  Securities 
marketed  in  this  country  consisted  largely  of  municipal 
bonds  which  were  sold,  usually  without  public  notice, 
to  local  bankers  who  in  turn  marketed  them  among 
insurance  companies,  savings  banks,  and  private  invest- 
ors. In  order  to  secure  a  better  price  for  bonds,  munic- 
ipalities began  to  advertise  their  new  issues  and  their 
sales  were  conducted  on  a  competitive  basis.  Blocks 
of  these  bonds  were  purchased  by  individuals  for  the 
purpose  of  selling  them  on  a  retail  basis,  and  these 
individuals  thus  performed  in  a  small  way  the  media- 
tion function  of  the  modern  investment  bankers. 

The  development  of  free  banking  encouraged  the 
organization  of  many  banks,  and  until  the  opening  of 
the  Civil  War  there  was  considerable  investment  of 
capital  in  bank  stock.  After  the  Civil  War  the  growth 
of  transcontinental  railways  led  to  the  issue  of  large 
blocks  of  bonds  which  were  absorbed  by  American  and 


THE   INVESTMENT   BANK  301 

European  investors,  whose  contributions  of  capital  made 
possible  also  the  organization  and  development  of  great 
industrial  trusts  at  the  opening  of  the  twentieth  century. 
The  war  changed  the  movement  of  capital  between 
Europe  and  America.  At  first  a  large  proportion  of 
American  railroad  and  industrial  securities  held  abroad 
were  repurchased,  and  later  the  war  obligations  of  the 
European  governments  found  a  market  in  the  United 
States. 

II.  Organization  of  an  Investment  Bank. 

The  modern  investment  bank  is  seldom  organized  in 
the  form  of  a  corporation,  but  rather  as  a  partnership 
including  from  two  to  twenty  members.  In  addition, 
large  commercial  banks  have  either  opened  bond  de- 
partments or  have  organized  separate  companies  which 
perform  all  the  functions  of  investment  houses. 

The  investment  bank  may  emphasize  certain  features 
of  its  business  more  than  others,  and  so  its  organization 
varies  accordingly.  It  usually  includes  buying,  sell- 
ing, statistics  and  treasury  departments.  The  function 
of  the  buying  department  is  to  investigate  the  various 
proposals  submitted  by  corporations  or  other  invest- 
ment houses  and  to  buy  the  securities  if  conditions 
warrant  such  action.  The  buying  departments  of  large 
investment  houses  usually  maintain  close  contact  \vith 
industries  in  which  they  are  interested.  Also  a  large 
firm  keeps  itself  informed  through  traveling  represent- 
atives, who  report  conditions  in  these  enterprises. 

After  the  securities  are  purchased  they  are  turned 
over  to  the  selling  department.  This  is  headed  by  a 
general  sales  manager,  who  directs  the  work  of  sales- 
men and,  at  times,  the  operation  of  the  branch  offices. 
The  majority  of  sales  are  made  by  representatives  who 
travel  "through  the  territory  allotted  to  them,  build  up 


302  BANKING  AND   BUSINESS 

a  regular  clientele,  and  thus  dispose  of  new  issues  of 
securities.  Each  salesman  keeps  in  touch  with  the  home 
office  and  reports  regularly  to  the  sales  manager.  If 
a  salesman  shows  ability  he  is  frequently  placed  in 
charge  of  a  branch  office  and  is  allowed  to  participate 
in  the  profits  of  the  business. 

The  sales  force  receives  considerable  assistance  from 
the  statistical  department,  which  compiles  lists  of 
customers,  securities  already  purchased  by  them,  and 
their  preferences  in  investments.  The  department 
aids  in  conducting  a  sales  campaign  by  prei:>aring  cir- 
culars and  press  notices.  This  department  also  answers 
customers'  inquiries  for  information  on  investments. 
Another  important  task  of  the  statistical  department 
is  to  analyze  proposals  submitted  to  the  consideration 
of  the  investment  house. 

The  treasury  department  is  concerned  with  such 
fiscal  affairs  as  the  securing  of  loans  from  banks  and 
the  carrying  of  accounts  of  customers  who  purchase 
securities  on  a  marginal  basis  or  on  an  installment  plan. 

III.  Classes  of  Investment  Banks. 

Investment  institutions  may  be  divided  into  three 
general  groups — wholesale  houses,  large  retail  houses, 
and  small  retail,  or  bond,  houses.  The  first  group  is 
composed  of  about  a  dozen  large  banking  firms  with 
many  correspondent  connections  abroad.  These  houses 
undertake  the  marketing  of  the  larger  issues  of  rail- 
roads and  of  foreign  governments,  exceeding  at  times 
$100,000,000  in  amount,  by  selling  them,  usually  not 
to  the  public  directly,  but  indirectly  through  other 
houses.  As  wholesale  houses  are  engaged  mainly  in  the 
purchase  of  securities,  the  organization  of  their  bu3dng 
department  is  of  special  importance,  and  so  it  usually 
retains  the  services  of  engineers,  accountants,  lawyers, 


THE   INVESTMENT  BANK  303 

and  other  experts  for  the  complete  evaluation  of  the 
properties  on  the  basis  of  wliich  the  securities  are  issued. 

For  the  sellmg  of  these  securities  the  wholesale  houses 
in  most  cases  associate  themselves  with  the  large  re- 
tailers, who  are  much  more  numerous.  These  usually 
have  their  home  office  in  New  York  City,  in  some 
other  Eastern  money  center,  or  in  Chicago,  and  operate 
in  other  important  cities  through  their  own  branches  or 
through  partnerships  and  corporations  which  are  in- 
dependently organized,  but  always  closely  affiliated 
with  the  home  office.  The  securities  companies  of 
national  banks  and  the  bond  departments  of  trust 
companies  are,  of  course,  not  permitted  to  organize 
branches,  but  instead  operate  correspondent  offices 
which  perform  about  the  same  activities  as  private 
investment  banks.  The  large  retailers  will  purchase 
securities  for  their  own  account  directly  from  the 
issuing  corporations  to  a  limited  extent  only,  and 
for  relatively  small  amounts.  In  the  case  of  large 
issues,  the  retailers  will  not  usually  assume  the  respon- 
sibility alone,  but  join  with  others  in  a  syndicate  or 
group  of  houses,  of  which  each  takes  over  a  portion  of 
the  securities.  As  the  main  task  of  a  large  retail  house 
is  the  disposing  of  securities,  the  sales  department  is 
the  most  important  unit  in  its  organization. 

Large  retail  houses  may  be  grouped  according  to  the 
form  of  the  securities  or  the  nature  of  the  issues  in  which 
they  are  interested.  Thus  there  are  houses  speciahzing 
in  bonds  or  stocks,  or  in  both  forms  of  securities.  Other 
firms  handle  only  such  issues  as  government  bonds, 
railroad,  public  utility,  or  industrial  securities.  While 
most  investment  banks  naturally  press  the  sale  of  their 
own  specialties  or  issues,  at  the  same  time  they  will 
also  execute  orders  to  buy  and  sell  other  stocks  and 
bonds  either  directly  as  members  of  the  various  stock 
exchanges  or  indirectly  through  brokers. 


304  BANKING  AND   BUSINESS 

The  branches  and  the  affihated  offices  of  the  large 
retailers  throughout  the  country  come  into  active  com- 
petition with  the  bond  houses  or  small  retailers.  These 
are  of  several  classes,  such  as  small  banks  and  broker- 
age houses  dealing  in  all  kinds  of  securities,  or  handling 
specialties  such  as  Standard  Oil  stocks,  equipment 
bonds,  and  issues  of  local  corporations.  The  organiza- 
tion of  the  small  investment  house  is  quite  similar  to 
that  of  the  large  retail  firm,  but  on  a  more  limited 
scale,  for  usually  the  buying  and  selling  departments 
are  conducted  by  only  one  person,  who  controls  the 
entire  business.  The  small  bond  house  at  times  finds 
difficulty  in  obtaining  high-grade  securities,  for  those 
yielding  a  satisfactory  profit  are  handled  by  the  large 
retail  houses  themselves,  which  allow  only  a  small 
commission  on  these  sales. 

IV.  Functions  of  an  Investment  Bank. 

As  already  indicated,  the  types  of  investment  banks 
considered  perform  in  general  one  or  more  of  the  fol- 
lowing functions :  (1)  investigating  proposals,  (2)  form- 
ing syndicates  for  underwriting,  (3)  selling  securities. 
In  addition,  investment  houses  may  render  the  public 
such  services  as  advice  in  selecting  securities,  informa- 
tion to  customers,  and  protection  in  case  of  failure  of 
the  corporation  issuing  the  securities.  These  functions 
are  exercised  by  the  several  classes  of  investment  banks 
to  a  degree  varying  with  their  size  or  special  interest. 
In  considering  the  nature  of  these  functions  no  par- 
ticular type  of  organization  will  be  kept  in  mind,  but, 
instead,  the  discussion  will  apply  to  all  types. 

1.  Investigation. 

Investment  banks,  especially  those  of  high  standing, 
exercise  caution  before  handUng  a  new  issue  of  securi- 


THE   INVESTMENT   BANK  30.5 

ties,  and  therefore  an  investigation  is  first  conducted. 
In  the  case  of  states  or  municipahties  the  investiga- 
tion may  be  omitted  entirely,  but  where  it  is  carried  out 
such  subjects  are  analyzed  as  the  taxing  power  of  the 
government,  the  limit  of  its  debt,  and  the  earning  abiUty 
of  the  population.  StabiUty  is  an  additional  factor 
to  be  considered  when  the  status  of  a  foreign  govern- 
ment is  concerned.  The  examination  of  a  public- 
service  corporation  such  as  a  gas  or  an  electric 
company  emphasizes  the  extent  of  the  franchise,  the 
nature  of  the  local  population,  the  kind  of  industries, 
and  public  control  over  rates. 

In  the  case  of  a  large  railroad  issue  a  more  compre- 
hensive sm'vey  must  be  made,  which,  because  of  the 
expense  involved,  can  be  undertaken  only  by  the 
wholesale  houses.  For  this  work  it  is  necessary  to 
retain  the  services  of  many  experts.  Engineers  com- 
plete a  physical  inventory  of  the  road,  lawyers  examine 
its  franchises  and  leases  as  well  as  the  legal  status  of 
securities  already  outstanding,  while  accountants  verify 
the  statements  submitted  by  the  corporation.  Due 
consideration  is  also  given  to  such  general  factors  as  the 
earnings  of  the  road,  the  ability  of  the  management, 
and  the  competition  of  other  Unes. 

The  same  factors  are  considered  in  analyzing  a  new 
industrial  enterprise.  In  this  case  the  intensity  of  the 
investigation  will  depend  upon  whether  the  prospective 
issuer  is  a  newly  formed  organization  seeking  funds 
for  promotion  purposes  or  an  old-estabhshed  corpora- 
tion with  securities  already  outstanding,  and  in  need 
of  money  for  the  enlargement  of  its  business.  In 
general,  investment  houses  handle  municipal,  pubUc 
utility,  and  railroad  issues  to  practically  any  amount, 
but  only  a  few  banks  of  standing  are  willing  to  take 
over  large  issues  of  industrial  corporations.  Hence 
some   lines   of   industries   are   unable   to   bring   their 


306  BANKING  AND   BUSINESS 

securities  on  the  market  through  investment  houses  of 
standing,  and  must  therefore  sell  them  directly  to  the 
public  or  through  bankers  and  brokers  of  less-known 
standing.  If  the  findings  of  the  investigation  prove 
favorable,  the  investment  house  may  enter  into  one  of 
two  different  business  relations  with  the  borrowing 
corporation.  The  latter  may  request  the  former  either 
to  purchase  the  securities  outright  at  a  stipulated  price 
and  to  sell  them  to  the  public  through  its  salesmen 
and  branches,  or  to  insure  the  sale. 

2.  Underwriting. 

The  corporation  could  possibly  market  its  own  se- 
curities directly  and  have  the  investment  bank  merely 
underwrite  the  issue  by  insuring  the  corporation  that 
if  the  securities  are  not  entirely  absorbed  in  the  open 
market  the  bank  will  take  the  remainder  at  an  agreed 
price.  For  this  service  the  issuing  corporation  pays 
the  underwriting  or  guaranteeing  bank  a  commission 
of  from  2  per  cent  to  5  per  cent.  In  the  case  of  a  large 
issue,  a  single  bank  may  be  unwilling  to  carry  the 
entire  amount,  because  of  size  and  risk,  and  the  bank 
forms  an  underwriting  syndicate  with  several  associ- 
ates. For  example,  bank  A  underwrites  an  issue  of 
$120,000,000  which  a  corporation  wishes  to  sell  directly 
to  the  pubUc,  and  the  bank  forms  a  syndicate  consist- 
ing of  itself  and  banks  B,  C,  D,  and  E.  Bank  A,  acting 
as  syndicate  manager,  underwrites  to  the  amount  of 
$40,000,000;  B  and  C,  $25,000,000  each;  and  D  and  E, 
$15,000,000  each.  The  corporation  then  offers  the 
securities  for  sale,  and  if  they  are  entirely  disposed  of, 
the  underwriters  receive  their  proportionate  commis- 
sion for  insuring  the  sale  of  the  issue,  without  being 
called  upon  to  carry  any  portion  themselves. 

However,  there  are  other  ways  of  underwriting.  For 
example,  a  purchasing  syndicate  may  be  organized  to 


THE   INVESTMENT  BANK  307 

buy  and  to  sell  the  securities.  The  X  Y  Z  Railroad 
issues  S10,0(X),000  first-mortgage  bonds  at  63-^  per 
cent  at  a  par  value  of  SIOO.  A  syndicate  consisting  of 
bank  A  as  syndicate  manager,  and  banks  B,  C,  D, 
and  E  as  underwriters,  pools  its  resources  or  forms 
what  is  known  as  a  joint  account  and  buys  the  securities 
from  the  issuing  corporation  at  a  price  of  S97.  From 
the  time  of  this  purchase  to  the  final  disposition  of  the 
securities,  the  issue  must  be  "carried"  or  taken  over  by 
the  buying  syndicate,  which  must  provide  the  corpora- 
tion with  an  amount  equal  to  the  purchase  price  of  the 
securities.  Funds  are  usually  borrowed  from  commer- 
cial banks  or  trust  companies,  which  accept  the  securi- 
ties themselves  as  collateral  on  this  amount.  The 
banks  lend  from  70  to  80  per  cent  of  the  total  amount, 
while  the  underwriters  furnish  the  remainder.  When 
each  underwriter  receives  a  separate  loan  from  its  bank, 
the  carrying  of  the  issue  is  then  said  to  be  ''divided," 
because  each  member  is  not  liable  for  the  borrowings 
of  its  associates,  but  only  for  its  ow^n  obligation.  In 
an  ''undivided"  carrying,  all  members  of  the  syndicate 
borrow  jointly  and  are  mutually  liable  for  the  full 
amount  of  the  loan.  As  a  matter  of  fact,  the  method  of 
undivided  carrying  is  mainly  used  at  the  present  time. 
The  members  of  an  underwriting  or  purchasing  syn- 
dicate may  enter  into  different  forms  of  agreements 
regarding  the  habihty  of  members  in  seUing  the  securi- 
ties. The  habihty  may  be  either  "limited"  or  "un- 
limited." In  a  limited  habihty  account  each  under- 
writer is  responsible  only  for  the  amount  which  he 
himself  has  assumed.  Under  an  unlimited  habihty 
agreement,  profits  are  shared  and  losses  borne  corre- 
sponding to  the  proportion  underwritten  -by  each 
member  and  not  with  the  amount  of  securities  which 
each  has  sold.  As  an  illustration  of  a  limited  liability, 
bank  A  has  underwritten  $500,000,  but  has  sold  only 


?m  BANKING   AND   BUSINESS 

$300,000,  and  so  it  must  take  over  the  difference  of 
$200,000  at  the  dissolution  of  the  syndicate.  On  the 
other  hand,  with  an  unUmited  Uabihty,  bank  A  has 
underwritten  securities  to  the  extent  of  one-tenth  of 
the  entire  issue,  or  $500,000,  and  sells  $600,000  of  these 
securities.  Other  members  of  the  syndicate  are  not  as 
successful  in  their  sales,  therefore  at  the  dissolution  of 
the  syndicate  there  is  still  a  balance  of  $2,000,000. 
Although  bank  A  has  effected  sales  in  excess  of  its 
subscription,  nevertheless,  it  is  compelled  to  take  over 
additional  securities  to  the  amount  of  one-tenth  of  the 
balance,  or  $200,000.  A  purchasing  syndicate  usually 
consists  of  a  few  members  only,  while  selling  syndicat^es 
may  consist  of  fifteen  to  twenty  associates,  or  even 
hundreds,  varying  with  the  size  of  the  issue. 

3.  Selling. 

Having  completed  the  investigation,  and  having  set- 
tled the  matter  of  underwriting,  the  investment  house 
now  begins  an  active  selling  campaign.  It  first  compiles 
a  careful  memorandum  or  circular  consisting  usually  of 
four  pages.  The  first  page  presents  such  details  as  the 
amount,  interest,  and  security  of  the  issue,  as  well  as 
the  net  income  of  the  corporation  over  a  period  of 
years.  The  circular  may  also  include  a  letter  from  the 
president  or  some  other  officer  setting  forth  prospective 
earnings  of  the  borrowing  corporation  and  the  future 
of  the  industry.  About  the  time  the  books  are  opened, 
advertisements  concerning  the  issue  appear  in  lead- 
ing newspapers.  If  the  issue  is  oversubscribed,  the 
securities  are  allotted  in  reduced  amounts.  Thus,  if 
there  is  an  oversubscription  of  25  per  cent,  a  subscriber 
who  has  applied  for  one  hundred  shares  will  receive 
only  seventy-five.  During  the  life  of  the  sjmdicate, 
members  must  sell  the  securities  only  at  the  agreed 
price,  and  every  effort  is  made  to  prevent  outsiders  from 


THE   INVESTMENT   BANK  309 

undercutting  this  price.  However,  syndicates  are  only 
temporary  organizations,  for  they  pass  out  of  existence 
after  the  disposal  of  the  securities,  which  are  then 
traded  at  fluctuating  rates.  If  the  securities  are  not 
sold  within  the  stipulated  time,  the  members  may 
either  prolong  the  hfe  of  the  syndicate  or  dissolve  it 
and  divide  proportionately  the  securities  among  the 
members  who  may  dispose  of  their  shares  at  any  pos- 
sible price.  Securities  are  thus  at  times  carried  for  a 
considerable  time,  and  in  such  cases  underwriters  may 
endure  heavy  losses. 

Even  after  the  sale  of  the  securities,  the  investment 
house  often  continues  to  take  an  active  interest  in  the 
issues  which  it  has  floated.  It  will  protect  customers 
to  whom  it  has  sold  the  securities,  and  as  far  as  possible 
will  support  the  market.  When  large  issues  are  in- 
volved, the  investment  house  may  seek  representation 
on  the  board  of  directors  in  order  to  exert  an  influence 
over  the  policy  of  the  corporation. 

V.  Services  of  Investment  Banks. 

Through  the  operations  considered  above,  investment 
banks  perform  important  services  for  both  borrowing 
corporations  and  the  investing  public.  To  the  former 
it  furnishes  fluid  capital  at  a  reasonable  cost,  antl  to 
the  latter  it  ofTers  opportunities  for  a  satisfactory  return 
on  surplus  funds. 

Valuable  aid  is  also  rendered  by  investment  houses 
to  the  borrowing  corporations,  in  time  of  reorganization 
and  failure,  especially  when  due  to  causes  ovvv  which 
their  management  has  no  control.  Investment  banks 
are  then  the  only  sources  for  new  capital,  as  the  pubhc 
is  unwilling  to  buy  the  securities  of  a  rorjioration  in 
default,  and  only  those  banks  which  are  able  to  investi- 
gate the  entire  situation  and  appreciate  tlu^  true  value 


310  BANKING  AND  BUSINESS 

of  the  corporation's  assets  are  willing  to  provide  new 
funds. 

An  investment  bank  of  standing  aims  to  sell  its 
clients  securities  of  reasonable  yield  and  safety  only. 
At  times,  the  selection  is  not  always  justified  by  eco- 
nomic events,  and  it  is  then  poUcy  to  advise  customers 
to  sell  these  securities  if  the  yield  has  become  unsatis- 
factory and  the  value  speculative.  In  order  to  main- 
tain its  reputation,  an  investment  bank  will  sometimes 
go  to  the  extent  of  paying  interest  to  holders  of  bonds 
on  which  the  issuing  corporation  has  defaulted. 


CHAPTER  XX 

SAVINGS   INSTITUTIONS 

I.  The  Savings  Bank  as  Compared  with  Commer- 
cial AND  Investment  Banks. 

Before  describing  the  various  classes  of  financial  in- 
stitutions for  the  accumulation  of  savings,  it  is  well  to 
consider  first  the  general  meaning  of  savings  banking  as 
compared  with  commercial  banking,  especially  as  re- 
lating to  deposits  and  loans.  AMiile  the  depositors  of 
commercial  banks  are  usually  business  men,  the  chents 
of  savings  banks  are  mainly  working  people  who  desire 
a  secure  depository  for  their  earnings.  The  deposits  of 
the  former  result  largely  from  the  granting  of  loans 
and  contain  a  relatively  small  proportion  of  cash,  which, 
on  the  other  hand,  constitutes  the  main  element  in 
savings  deposits. 

The  funds  of  savings  banks  possess  many  of  the 
features  of  time  deposits  of  commercial  banks,  since 
both  are  lodged  with  the  banks  for  the  purpose  of  ob- 
taining an  int-erest  yield.  This  return  can  be  granted 
by  the  banks,  because  both  savings  and  time  deposits 
are  generally  inactive,  and,  moreover,  may  not  be 
withdrawn  immediately  upon  demand,  but  only  upon 
due  notice  of  from  thirty  to  sixty  days  in  advance.  A 
characteristic  of  the  savings  deposit  is  the  insistence 
by  the  bank  that  the  customer  produce  his  pass  book 
before  making  any  withdrawal. 

As  the  savings  bank  thus  deals  in  long  rather  than  in 
short  term  credit,  it  partakes  of  the  nature  of  an  invest- 


312  BANKING  AND   BUSINESS 

ment  institution.  The  savings  bank  and  the  invest- 
ment house  are  similar  in  that  they  both  act  as  inter- 
mediary agents  between  investors  and  borrowers.  The 
difference  hes  in  the  fact  that  the  investment  bank 
sells  securities  directly  to  the  lenders,  while  the  savings 
bank  operates  indirectly  by  receiving  deposits  and  plac- 
ing them  in  investments.  In  the  first  case,  investors 
secure  their  returns  in  the  form  of  dividends  or  inter- 
est from  the  borrowers,  while  depositors  receive  interest 
from  the  bank. 

Since  a  savings  bank  is  not  required  to  pay  out  de- 
posits on  demand,  it  is  able  to  make  loans  for  a  longer 
period  of  time,  as  compared  with  the  commercial  bank, 
because  the  latter  holds,  for  the  most  part,  deposits 
payable  on  demand,  and  so  can  extend  only  short 
advances.  The  savings  bank  invests  largely  in  real- 
estate  mortgages,  railroad  and  government  bonds.  The 
bank  is  not  entirely  free  in  selecting  these  investments, 
for  they  are  more  or  less  prescribed  by  state  law.  Such 
legislation  is  due  to  the  general  belief  that  savings 
deposits  are  entitled  to  additional  protection  and 
should  therefore  be  placed  only  in  special  investments 
which  offer  adequate  security.  An  individual  possess- 
ing surplus  funds  has  the  choice  of  investing  them  in 
securities  directly,  or  in  securities  indirectly  by  deposit- 
ing in  a  savings  bank.  By  following  the  former  policy, 
the  saver  gains  the  advantage  of  a  higher  >^eld,  but  at 
the  same  time  labors  under  certain  disadvantages.  For 
instance,  he  does  not  possess  sufficient  knowledge  of 
the  investment  field  to  judge  relative  values  and  to 
discriminate  between  high-grade  and  low-grade  securi- 
ties. His  savings  are  usually  accumulated  in  amounts 
too  small  for  their  immediate  placement  in  stocks  and 
bonds,  which  are  seldom  issued  in  denominations  of 
less  than  $100  each.  To  some  extent  this  objection 
to  direct  investment  of  small  savings  is  overcome  by 


SAVINGS   INSTITUTIONS  313 

the  plan  of  certain  brokerage  houses  of  accepting  par- 
tial payments  on  securities  purchased,  and  of  certain 
companies  in  issuing  real-estate  mortgage  bonds  in 
amounts  as  low  as  SI 00.  Even  if  the  saver  were  in 
position  to  find  in\'estments  which  are  safe  and  of 
small  denomination,  he  would  still  be  unable  to  divereify 
the  risk.  The  soundest  investments  are  subject  to 
fluctuations  in  value,  and  losses  can  be  overcome  only 
by  a  proper  distribution  of  funds.  This  is  impossible 
for  the  individual  with  limited  capital,  and  thus  he 
cannot  avoid  loss  if  the  investment  in  which  he  has 
placed  his  savings  depreciates  in  value.  The  problem 
of  marketabihty  also  remains,  and  a  contingency  may 
arise  in  which  the  individual  needs  cash  inmiediately 
and  he  may  then  be  forced  to  sell  his  investment  at  a 
sacrifice. 

These  disadvantages  encountered  by  the  man  of 
moderate  means  who  follows  the  method  of  direct  in- 
vestment are  overcome  to  a  large  extent  by  creating 
a  savings  account.  In  the  first  place,  the  bank  has  a 
better  understanding  of  investments,  for  it  is  contin- 
ually placing  funds  on  a  large  scale  and  is  therefore 
able  to  secure  expert  advice.  Secondly,  no  saving  is 
too  small  to  be  accepted,  for  some  banks  take  a  single 
deposit  as  low  as  ten  cents.  It  must  be  remembered 
that  the  savings  bank  is  receiving  numerous  deposits, 
small  in  their  separate  amounts  but  large  enough  in 
the  aggregate  to  enable  the  bank  to  spread  its  invest- 
ments over  various  fields  of  business  interests.  This 
very  diversity  brings  security,  for  a  loss  on  one  invest- 
ment is  compensated  by  a  gain  on  another.  Lastly, 
the  savings  bank  gives  the  depositor  the  assurance 
that  his  funds  are  available  practically  on  demand  and 
with  no  loss  excepting  possibly  an  amount  of  int€rest 
which  has  accrued  between  the  dat^s  of  deposit  and  of 
withdrawal.    For  these  reasons  the  sa\'ings  bank  per- 


314  BANKING  AND   BUSINESS 

forms  a  distinct  service  to  the  individual,  who  is  thus 
encouraged  to  practice  thrift  and  to  lay  aside  funds  for 
later  use. 

The  savings  bank  meets  a  social  need  in  furnish- 
ing capital  for  the  use  of  borrowers.  The  savings  of 
the  community  are  accumulated  and  made  available 
for  the  building  of  homes,  the  construction  of  railroads, 
and  the  undertaking  of  other  worthy  enterprises. 

II.  The  Organization  of  a  Mutual  Savings  Bank. 

In  the  above  description  of  the  nature  of  the  savings 
bank,  it  has  been  conceived  as  a  single  institution,  but 
it  is  organized  in  various  forms,  of  which  the  most  im- 
portant is  the  mutual  savings  bank. 

The  mutual  type  was  the  original  bank  for  savings 
and  the  first  was  organized  in  England  in  1810.  Dur- 
ing the  early  half  of  the  nineteenth  century  similar 
banks  were  established  in  New  England  and  New  York, 
but  the  movement  did  not  extend  beyond  the  North- 
eastern states.  In  this  area  on  June  30,  1921,  the 
total  deposits  of  mutual  savings  banks  amounted 
to  $5,575,181,  000.  These  resources  have  a  special  sig- 
nificance in  finance,  since  they  represent  not  exten- 
sions of  credit  by  banks,  but  deposits  of  actual  funds 
by  customers. 

The  purpose  in  organizing  a  mutual  savings  bank 
has  been  philanthropic  rather  than  commercial.  Origi- 
nally these  institutions  were  estabUshed  for  the  purpose 
of  encouraging  thrift  among  the  poorer  class  and  of 
improving  their  welfare.  The  founders  were  actuated 
by  charitable  motives  and  were  not  expected  to  derive 
any  profit  from  the  undertaking.  This  theory  is  still 
applied  in  the  case  of  the  mutual  savings  bank,  for  it 
is  organized  and  operated  by  a  group  of  persons  known 
as  trustees,  who  are  forbidden  by  law  to  receive  any 


SAVINGS   INSTITUTIONS  315 

compensation  for  their  services.  In  fact,  the  organizers 
must  contribute  to  an  initial  fund  to  meet  the  expenses 
of  starting  the  new  bank  and  to  operate  it  until  earnings 
render  it  self-supporting,  at  which  time  the  contribu- 
tions are  returned. 

The  mutual  savings  bank  is  not  operated  through 
capital  derived  from  the  sale  of  stocks,  for  the  busi- 
ness is  conducted  through  funds  left  by  depositors, 
who  are  the  real  owners  of  the  bank.  Thus  the  income 
which  they  recei\'e  is  technically  called  a  dividend, 
but  because  of  its  certainty  of  pajment  and  stabihty 
of  rate  it  is  popularly  regarded  as  interest.  Although 
they  are  in  a  sense  the  o\Miers  of  the  mutual  banks,  the 
depositors  exercise  neither  control  over  the  manage- 
ment nor  choice  in  the  selection  of  the  trustees.  The 
first  trustees  are  appointed  by  the  original  organizers 
and  later  additional  trustees  are  elected  by  the  board 
itself,  thus  constituting  it  a  self -perpetuating  body. 

The  trustees  of  a  large  mutual  savings  bank  are 
divided  into  committees  ^^dth  duties  quite  similar  to  the 
directors  of  a  commercial  bank.  The  finance  com- 
mittee passes  upon  all  applications  for  loans  on  mort- 
gages and  approves  all  purchases  of  securities.  In 
New  York  State,  a  trustee  may  not  receive  a  loan 
from  the  bank.  An  auditing  committee  examines  the 
books  of  the  institution  and  verifies  all  receipts  and 
disbursements,  while  appointments  and  discharges  of 
employees  are  made  by  a  personnel  committee. 

The  duties  of  the  higher  officers  are  about  the  same 
as  in  a  commercial  bank.  The  president,  as  a  member 
of  the  board  of  trustees,  presides  over  meetings.  As 
chief  executive  he  manages  the  bank,  and  in  this  task 
he  is  aided  by  one  or  more  vice-presidents.  A  treas- 
urer performs  duties  similar  to  those  of  a  cashier  in  a 
commercial  bank.  He  has  custody  of  cash,  securities, 
and  other  property  of  the  bank;    he  also  records  the 


316  BANKING   AND   BUSINESS 

minutes  of  trustee  meetings,  keeps  the  bank  ledgers, 
conducts  correspondence,  and  in  general  directs  the 
work  of  the  staff.  In  a  large  bank  the  treasurer  is 
relieved  of  these  purely  clerical  duties,  which  devolve 
upon  a  secretary.  The  work  is  sometimes  divided 
further  by  transferring  the  keeping  and  the  auditing  of 
the  books  to  an  officer  known  as  the  comptroller. 

As  the  operation  of  the  savings  bank  is  much  simpler 
than  that  of  the  commercial  bank,  there  are  fewer 
departments.  There  is  no  need  for  an  exchange  divi- 
sion, since  savings  banks  do  not  present  checks  on 
one  another.  The  departments  deal  principally  with 
deposits  and  investments.  One  department  concerns 
itself  exclusively  with  the  opening  of  new  accounts. 
Deposits  and  withdrawals  are  handled  by  a  receiving 
and  a  paying  teller;  another  department  has  charge 
of  loans  on  mortgages  and  investments  in  securities, 
and  a  head  bookkeeper  supervises  the  work  of  the 
ledger  clerks.  In  general,  the  bookkeeping  of  a  savings 
bank  does  not  present  the  many  difficulties  found  in 
a  commercial  bank,  and  the  handhng  of  deposits  and 
the  making  of  investments  possess  the  only  distinctive 
features  which  need  consideration  in  detail. 

III.  Deposits  of  Savings  Banks. 

Savings  banks  carry  single-name,  joint,  trustee,  and 
society  accounts.  Most  important  is  the  single-name 
account,  opened  by  an  individual  in  his  own  name,  and 
he  alone  has  control  over  deposits  and  withdrawals. 
A  joint  account  is  owned  by  two  persons,  and  either  one 
may  draw  the  funds.  A  trustee  account  is  opened  by 
one  person  in  favor  of  another,  but  it  is  payable  solely 
to  the  trustee  himself,  and  only  after  his  death  are  the 
rights  of  the  beneficiary  recognized  by  the  bank. 
A  treasurer  may  deposit  the  funds  of  a  lodge  or  church 


SAVINGS   INSTITUTIONS  317 

organization  in  what  is  known  as  a  society  account, 
and  from  it  he  can  withdraw  money  as  the  official  repre- 
sentative. All  accounts  are  usually  restricted  to  a 
maximum  limit,  which  in  New  York  State  amounts  to 
five  thousand  dollars,  since  savings  banks  are  intended 
only  for  persons  of  moderate  means. 

An  account  with  a  savings  bank  is  opened  in  a 
manner  somewhat  different  from  that  in  a  commercial 
bank.  As  the  former  bank  will  not  extend  loans  to  the 
prospective  customer,  there  is  little  need  of  an  intro- 
duction or  of  an  investigation  into  his  credit  standing. 
The  only  relations  between  customer  and  sa\'ings  bank 
will  consist  of  leaving  and  ^Wthdrawing  deposits,  and  to 
enable  the  entering  of  these  transactions  several  records 
must  be  compiled.  The  new  customer  fills  out  a  signa- 
ture card  which  requii'es  such  information  as  his  age, 
date  of  birth,  residence,  occupation,  name  of  parents, 
and  general  facts  relating  to  his  family  history.  This 
card  supplies  the  paying  teller  with  test  questions  wliich 
will  later  be  used  in  identifying  the  depositor  when  he 
wishes  to  withdraw  money. 

IV.  The  Pass  Book. 

With  the  account  thus  opened,  the  depositor  receives 
a  pass  book  which  from  his  standpoint  is  the  most 
important  of  all  savings-bank  documents.  It  serves 
(a)  as  a  contract  between  customer  and  bank,  (b)  as  a 
miniature  ledger  of  all  deposits  and  withdi*awals,  and 
(c)  as  an  instrument  which  is  assignable.  The  pass 
book  contains  a  statement  of  the  regulations  governing 
both  depositor  and  bank.  In  general,  the  former  is 
regarded  as  a  creditor  who  has  gi\'en  a  sum  of  money 
to  the  latter,  who  thus  becomes  the  debtor.  The  bank 
promises  to  exercise  due  care  in  investing  this  fund, 
while  the  client,  on  his  part,  consents  to  follow  certain 


318  BANKING   AND   BUSINESS 

rules  relating  to  the  making  and  withdrawing  of  de- 
posits, and  in  all  these  transactions  he  agrees  to  present 
his  pass  book. 

The  importance  of  this  instrument  can  best  be  seen 
by  tracing  the  manner  in  which  a  savings  bank  recei\'es 
and  pays  deposits.  A  deposit  usually  consists  of  cash, 
but  occasionally  checks  are  also  offered.  To  be  accept- 
able these  checks  must  be  drawn  directly  to  the  order 
of  the  bank,  or  to  the  order  of  the  depositor,  and  then 
properly  indorsed  by  him.  The  items  thus  presented 
are  entered  on  a  deposit  shp  which  is  usually  filled  out 
by  the  customer  himself,  but  if  he  cannot  write,  a  clerk 
of  the  bank  is  permitted  to  complete  the  record.  The 
customer  then  presents  the  deposit,  the  shp,  and  the 
pass  book  to  the  receiving  teller,  who  enters  the  amount 
in  the  pass  book. 

While  the  savings  bank  thus  receives  the  deposit  in 
much  the  same  way  as  in  the  commercial  bank,  a  with- 
drawal is  more  complicated,  because  special  care  must 
be  taken  to  safeguard  the  interests  of  savings  deposi- 
tors. As  they  do  not  withdraw  their  money  regularly, 
the  paying  teller  has  little  opportunity  of  knowing 
them  personally.  Besides,  they  are  often  foreigners 
or  individuals  with  little  knowledge  of  business,  and 
are  therefore  less  able  to  protect  themselves  against 
fraud . 

In  withdrawing  money  from  a  savings  bank,  the  cus- 
tomer signs  either  a  check  or  a  receipt.  The  check  is 
quite  similar  to  the  ordinary  instrument  used  in  draw- 
ing against  a  commercial  account.  This  withdrawal 
order  may  read  as  follows: 

To  the  X  Savings  Bank 

Pay  to  myself  or  order  the  sum  of 

one  hundred  dollars 

and  charge  my  pass  book  Number  10 


SAVINGS  INSTITUTIONS  319 

A  receipt  for  the  payment  of  savings  funds  is  filled  out 
by  the  bank  clerk  and  then  signed  by  the  customer. 
This  form  contains  simply  a  statement  which  reads: 

Received  from  the  X  Savings  Bank 
on  account  of  pass  book  Number  10 

The  checks  and  the  receipts  used  in  largo  savings  banks 
are  often  printed  in  even  denominations  of  $5,  $10, 
$50,  or  $100  for  the  convenience  of  customers.  The 
signature  is  compared  with  the  specimen  previously 
written  by  the  depositor  when  he  opened  the  account. 
In  the  event  of  forgery  the  savings  bank  is  not  Hable  to 
the  same  degree  as  is  the  commercial  bank.  It  will  be 
recalled  that  the  latter  is  fully  responsible  if  it  makes 
payment  on  a  forged  check.  However,  the  savings 
bank  is  not  compelled  by  law  to  know  the  signature  of 
its  customers.  A  surer  means  of  identification  than 
test  questions  or  even  a  signature  of  the  depositor  is 
his  fingerprint.  This  method  is  based  on  the  well- 
known  principle  that  the  lines  on  the  finger  tips  are 
formed  differently  in  almost  every  individual  and  thus 
he  can  easily  be  identified.  Savings  banks  are  now 
appljdng  this  test,  especially  to  depositors  who  are 
unable  to  write.  When  the  customer  has  met  this 
test,  the  amount  of  his  withdrawal  is  recorded  on  the 
bank's  ledgers  and  entered  in  the  pass  book. 

\\Tiile  the  bulk  of  deposits  and  ^\^thdrawals  are  made 
in  person  over  the  counter,  these  transactions  can  also 
be  conducted  by  mail.  In  this  way  the  bank  receives 
deposits  of  cash,  checks,  and  money  orders,  and  also 
complies  with  the  requests  of  customers  for  pajinent 
by  sending  them  drafts.  In  every  case  the  pass  book 
must  be  forwarded  to  the  bank. 

Because  of  the  care  taken  to  enter  all  deposits  and 
withdrawals  in  the  pass  book,  it  always  represents  the 
net  balance  which  the  bank  owes  the  depositor.    He  is 


320  BANKING  AND  BUSINESS 

therefore  able  to  use  his  book  as  an  instrument  assign- 
able to  another  person.  The  pass  book  can  be  used 
when  the  depositor  buys  property  from  a  seller,  who 
in  exchange  receives  title  to  the  funds  in  the  savings 
bank.  A  depositor  can  also  use  his  pass  book  for  the 
purpose  of  pledging  it  as  collateral  for  a  loan. 

Due  to  the  importance  of  the  pass  book,  the  bank 
exercises  utmost  care  in  issuing  a  duplicate  when  the 
original  is  lost  by  the  depositor.  He  is  expected  to 
give  immediate  notice  of  such  loss  to  the  bank,  which 
then  stops  further  payment  against  the  account.  An 
advertisement  describing  the  book  is  usually  inserted 
in  the  newspapers  at  the  customer's  expense.  If  the 
account  is  large,  the  bank  may  further  require  an 
affidavit  in  which  the  depositor  attests  to  the  loss,  and 
may  even  exact  a  bond  of  indemnity  covering  the  bank 
to  twice  the  amount. 

In  the  case  of  most  savings  accounts,  deposits  about 
equal  withdrawals,  and  the  increment  from  year  to 
year  results  from  the  amount  of  interest  paid  by  banks 
to  their  customers. 

The  savings  bank  pays  interest  not  on  the  average 
balance,  but  on  the  lowest  amount  which  remains  to 
the  credit  of  the  customer  within  a  limit  of  time. 
If  before  the  end  of  this  time  the  customer  withdraws 
any  portion,  he  loses  the  interest  on  that  amount. 
Interest  is  usually  computed  from  the  1st  of  January 
and  July,  but  some  banks  grant  it  from  the  beginning 
of  each  month.  There  is  a  recent  tendency  to  shorten 
the  reckoning  of  interest  to  one  month.  This  method 
possesses  certain  advantages  in  that  it  renders  the 
business  of  the  bank  more  uniform  by  spreading  the 
interest  payments  over  the  entire  year,  and  it  encour- 
ages systematic  saving  among  customers  who  otherwise 
are  inclined  to  withhold  deposits  until  the  beginning  of 
the  interest  period.    To  the  bank,  however,  the  monthly 


SAVINGS  INSTITUTIONS  321 

plan  usually  brings  a  net  loss,  for  profits  tend  to  decline 
directly  with  decrease  in  the  period  of  interest  payment. 
This  is  due  to  the  fact  that  a  bank  has  at  its  disposal 
a  large  amount  of  money  bearing  no  return  to  the 
depositor  until  the  next  interest  date,  but  these  funds 
at  the  same  time  serving  as  an  earning  asset  to  the 
bank  itself. 

V.  Investments  of  Savings-banks. 

The  second  phase  of  savings-bank  operation  is  the 
investment  of  funds  intrusted  by  depositors.  In  in- 
vesting these  deposits  a  policy  should  be  followed  which 
assures  the  ends  of  safety,  diversity,  hquidity,  and 
productivity.  Safety  should  be  the  prime  considera- 
tion, for  the  bank  is  obhgated  to  maintain  intact  the 
savings  of  its  depositors.  This  security  is  partly  ob- 
tained by  diversifying  or  distributing  investments  over 
more  than  one  interest  and  in  more  than  one  locahty. 
It  is  also  highly  essential  for  a  bank's  investments  to 
possess  liquidity,  so  that  they  can  be  readily  sold  on 
the  market,  and  the  funds  made  available  to  meet  any 
sudden  demand  of  depositors  for  their  money.  Pro- 
ductivity is  desirable,  for  a  bank  naturally  seeks  a  high 
income  on  its  investments  in  order  to  pay  a  reasonable 
yield  to  customers  on  their  deposits. 

Minor  influences  sometimes  determine  the  invest- 
ments of  savings  banks.  They  are  expected  to  give 
preference  to  local  interests,  so  that  the  savers  are 
directly  or  indirectly  the  users  of  the  money.  On  this 
theory  that  the  depositors'  funds  should  be  "kept  at 
home,"  savings  banks  in  general  invest  a  considerable 
part  of  their  funds  in  mortgages  based  on  pi'operty 
near  by,  and  in  bonds  issued  by  governments  in  the 
same  locality. 

The  savings  bank  is  by  no  means  free  in  selecting 


322  BANKING  AND   BUSINESS 

its  investments,  for  these  are  usually  prescribed  by- 
state  laws.  They  embody  to  some  extent  the  above 
principles  of  investment,  but  the  statutes  represent 
rather  the  historical  evolution  of  the  state's  judgment 
on  legal  investments  for  savings  banks.  The  mortgage 
on  real  estate  has  always  been  regarded  as  a  desirable 
form  of  investment,  and  government  bonds  are  also 
considered  satisfactory.  The  buying  of  nongovern- 
ment securities  was  not  permitted  until  the  end  of  the 
nineteenth  century,  when  some  of  the  states  first  per- 
mitted the  purchase  of  railroad  issues.  Savings  banks 
were  thus  limited  to  investments  with  long  maturities, 
and  only  in  recent  years  have  they  been  free  to  lend 
their  funds  on  short-term  obUgations  such  as  collater- 
aled  promissory  notes  and  bankers'  acceptances.  In 
general,  there  has  been  a  tendency,  especially  in  Massa- 
chusetts and  New  York,  to  widen  the  sphere  of  invest- 
ments for  savings  banks. 

In  analyzing  the  relative  importance  of  these  various 
investments,  particular  consideration  wdll  be  given  to 
the  regulations  as  found  in  the  savings-bank  law  of 
New  York. 

1.  Real-estate  Mortgages. 

In  that  state  the  mutual  savings  banks  have  invested 
about  one-half  of  their  funds  in  real-estate  mortgages. 
WTien  a  prospective  borrower  wants  a  savings  bank  to 
advance  him  a  loan  on  the  pledge  of  his  real  estate, 
he  first  fills  out  a  formal  apphcation  describing  his 
property.  It  is  then  evaluated  or  appraised  by  a  com- 
mittee of  the  trustees,  for  the  loan  must  not  exceed  60 
per  cent  of  the  value  of  the  property  if  improved,  and 
not  over  40  per  cent  if  unimproved.  In  estimating  the 
worth  of  the  property,  such  factors  are  considered  as 
the  cost  of  construction,  the  further  upkeep,  and  the 
income  derived  from  rentals.     In  examining  city  prop- 


SAVINGS   INSTITUTIONS  323 

erty,  due  consideration  is  also  given  to  desirability  of 
the  neighborhood  and  extent  of  transportation  facili- 
ties. In  appraising  a  farm,  quality  of  the  soil,  kind  of 
crops,  condition  of  buildings,  and  nearness  to  markets 
are  carefully  studied.  If  the  report  is  favorable,  the 
title  to  property  is  searched  by  an  attorney  or  a  title 
company.  An  abstract  is  made  of  the  title,  from  which 
the  bank  learns  whether  the  owTier  has  a  clear  or 
undisputed  right  to  the  property  and  whether  it  is 
free  from  prior  taxes  or  other  claims.  The  property 
is  then  insured  against  fire,  so  that  payment,  in  case 
of  loss,  is  made  in  favor  of  the  bank  as  mortgagee. 
The  bank  closes  the  transaction  by  recording  the 
mortgage  in  the  office  of  the  local  government  and  by 
sending  the  borrower  a  check  to  cover  the  loan.  \Miile 
a  savings  bank  in  a  city  rarely  extends  mortgage  loans 
on  distant  property,  country  banks  lend  quite  freely 
in  New  York  and  other  large  cities  because  of  the 
scarcity  of  local  loans.  Economic  conditions  and  like- 
\\dse  real-estate  values  are  more  stable  in  the  country, 
where  the  character  of  the  neighborhood  changes  but 
slowly  and  where  improvement  in  transportation  sel- 
dom alters  a  community  for  better  or  for  worse. 
Although  rural  property  possesses  stability,  it  usually 
has  restricted  salability.  In  this  respect,  an  urban  lot 
and  building  possesses  an  advantage,  since  a  buyer  can 
be  found  more  readily.  In  general,  limited  marketability 
is  the  fundamental  weakness  of  all  real  estate  as  col- 
lateral, especially  when  contrasted  with  government 
or  railroad  bonds.  These  are  issued  in  series  of  large 
numbers,  of  w^hich  each  bears  the  same  value  as  any 
of  the  others  and  so  possesses  a  relatively  uniform 
market  price  to  all  buyers.  However,  each  building  or 
plot  of  ground  possesses  features  peculiar  to  itself  and 
stands  as  a  separate  unit.  Such  property  has,  there- 
fore, no  definite  market,  but  is  sold  according  as  it 


324  BANKING  AND  BUSINESS 

appeals  to    the  particular  wishes   of   the  .individual 
buyer. 

Under  these  conditions  real  estate  at  times  becomes 
a  collateral  from  which  a  bank  finds  difficulty  in  realiz- 
ing its  money.  It  sometimes  happens  that  a  borrower 
who  has  given  a  piece  of  property  as  security  for  a  loan 
is  unable  to  repay  the  money.  Through  the  legal  process 
of  foreclosure  the  property  is  placed  at  auction,  and  if 
no  buyer  appears  the  bank  must  purchase  it  in  order  to 
escape  loss.  This  situation  is  unsatisfactory  to  the 
bank,  especially  if  it  is  unable  to  dispose  of  the  property 
at  a  time  when  funds  are  needed  to  meet  the  demands 
of  depositors  for  cash.  To  avoid  this  embarrassment 
the  bank  may  have  a  mortgage  guaranteed  by  a  realty 
company,  which  for  a  small  charge  assumes  entire  care 
during  the  life  of  the  loan  and  assures  the  payment  of 
the  yearly  interest  and  final  principal.  This  prac- 
tice is  especially  favored  by  country  banks  investing 
in  mortgages  on  city  property.  A  bank  may  lessen 
the  number  of  foreclosures  on  property  held  as  security 
by  insisting  upon  the  amortization  of  the  loan.  Under 
this  plan  the  borrower  pays  off  a  certain  portion  of  the 
loan  at  the  end  of  every  year  or  a  shorter  interval.  Thus 
at  maturity  the  loan  is  entirely  Hquidated  or  at  least 
the  principal  is  considerably  reduced. 

2.  Investment  in  Bonds. 

Because  of  the  difficulty  encountered  in  disposing  of 
their  mortgage  holdings  in  time  of  need,  savings  banks 
invest  heavily  in  bonds,  which  possess  great  liquidity. 
The  savings  banks  are  usually  permitted  by  law  to  hold 
the  obligations  of  such  governments  as  (1)  the  United 
States,  (2)  the  state  in  which  the  bank  is  located, 
(3)  any  local  subdivision  thereof,  (4)  any  outside  state 
or  city  meeting  certain  tests  of  safety,  such  as  adequate 


SAVINGS   INSTITUTIONS  325 

population,  limit  of  indebtedness,  and  a  satisfactory 
record  in  honoring  its  obligations  in  the  past.  A  few 
states  permit  savings  banks  to  purchase  bonds  issued 
by  the  more  stable  European  governments. 

The  investments  of  savings  banks  in  nongovernment 
securities  are  usually  Umited.  The  purchase  of  stocks  is 
generally  prohibited,  and  in  some  states  even  bonds  of 
industrial  and  public-service  corporations  are  forbidden. 
Savings  banks  in  New  York  State  must  confine  their 
nongovernment  investments  exclusively  to  first-mort- 
gage bonds  of  a  selected  list  of  railroads.  These  bonds, 
especially  if  listed  on  the  Stock  Exchange,  can  readily 
be  sold  by  the  bank  if  it  is  in  need  of  cash,  but  until  the 
middle  of  1921  this  advantage  was  offset  by  the  weak- 
ness of  bond  values.  These  dechnes  were  caused  not  by 
any  doubt  as  to  payment  of  interest  or  principal,  but 
by  the  low  yield  as  compared  with  the  high  rate  of 
the  money  market.  Nor  was  there  any  opportunity 
to  adjust  the  yield,  for  these  securities  usually  had  a 
long  maturity. 

3.  Short-term  Investments. 

It  is  therefore  necessary  for  a  savings  bank  to  place 
some  of  its  funds  in  a  form  which  possesses  both  sta- 
bihty  of  value  and  marketabihty.  A  checking  account 
may  be  maintained  with  a  commercial  bank,  which 
must  repay  part  or  even  the  full  amount  on  demand, 
but  such  funds  yield  only  a  small  rate  of  interest.  In 
order  to  secure  a  satisfactory  yield  and  at  the  same  time 
retain  the  necessary  hquidity  for  their  holdings,  sav- 
ings banks  are  usually  permitted  to  invest  in  obligations 
with  short  maturities.  In  New  York  State,  loans  may 
be  made  on  a  demand  promissory  note  signed  by  a 
borrower,  who  hypothecates  such  securities  as  the  sav- 
ings bank  itself  is  permitted  to  purchase,  but  the  loan 


326  BANKING   AND   BUSINESS 

in  any  case  must  not  exceed  90  per  cent  of  the  market 
value  of  this  collateral.  Savings  banks  are  thus  able 
indirectly  to  lend  in  the  call-money  market  at  a  satis- 
factory rate  through  a  commercial  bank  which  directly 
places  the  funds  and  in  return  gives  its  demand  note 
secured  by  Liberty  Bonds.  A  savings  bank  may  also 
lend  on  a  ninety-day  promissory  note  of  a  borrower 
who  pledges  as  collateral  either  a  pass  book  of  another 
savings  bank  or  a  class  of  mortgage  in  which  the  bank 
itself  may  invest.  The  loan  must  not  exceed  90  per 
cent  of  the  amount  entered  on  the  pass  book,  or  75  per 
cent  of  the  value  of  the  mortgage. 

A  greater  Uquidity  has  been  added  to  the  assets  of 
savings  banks  by  the  passing  of  state  laws  which  per- 
mit the  purchase  of  bankers'  acceptances.  These  must 
be  of  a  kind  eligible  for  purchase  in  the  open  market 
by  a  Federal  Reserve  bank,  and  thus  a  savings  bank 
may  count  such  holdings  as  a  secondary  reserve  which 
can  be  readily  converted  into  cash. 

The  investments  of  savings  banks  have  varied  in 
their  distribution  during  the  past  decade.  Not\^dth- 
standing  the  urgent  need  of  additional  buildings  to 
meet  the  housing  problem  in  the  large  cities,  the  pro- 
portion of  loans  made  on  mortgages  has  declined, 
because  the  rate  of  interest  on  such  loans  has  been 
limited  to  6  per  cent  by  the  state  laws  against  usury. 
Railroad,  municipal,  and  state  bonds  have  lost  favor, 
for  until  recently  their  yield  has  been  comparatively 
low.  Savings  banks  have  transferred  their  funds  largely 
from  these  securities  to  Liberty  Bonds,  Victory  Notes, 
and  certificates  of  indebtedness,  which  have  yielded  a 
greater  return  and  which  at  the  same  time  have  fur- 
nished the  highest  possible  security.  Acceptances  bear- 
ing a  satisfactory  return  and  offering  a  quick  salability 
have  also  attracted  no  inconsiderable  amount  of  sa\'ings- 
bank  funds. 


SAVINGS  INSTITUTIONS  327 

VI.     Classes  of  Savings  Banks. 

In  addition  to  the  mutual  savings  bank  just  con- 
sidered, there  are  several  other  forms  of  savings  institu- 
tions to  be  found  in  the  United  States,  such  as,  (1) 
stock  savings  bank,  (2)  savings  department  of  a  com- 
mercial bank,  (3)  guaranty-fund  bank,  and  (4) 
co-operative  association.  In  addition  to  these  institu- 
tions, which  are  operated  by  privately  owned  capital, 
there  is  also  the  postal  savings  system  conducted  by 
the  federal  government.  In  several  European  countries 
savings  banks  are  also  operated  by  municipalities. 

1.  Stock  Savings  Banks. 

The  mutual  savings-bank  plan  has  not  extended  to 
the  West  and  the  South,  where  savings  institutions  are 
formed  not  for  philanthropic  purposes,  but  rather  for 
profits,  and  are  therefore  organized  the  same  as  other 
corporations.  They  are  called  stock  savings  banks, 
and  their  earnings  are  paid  to  shareholders,  while  de- 
positors receive  a  fixed  rate  of  interest.  The  stockholders 
also  possess  the  right  to  elect  directors,  who  control  the 
affairs  of  the  bank.  Hence  mutual  and  stock  savings 
banks  differ  as  to  motive,  o\Miership,  and  management. 
Both  types  possess  the  common  feature  of  recei\'ing 
only  savings  accounts  and  neither  enters  into  the  field 
of  commercial  banking. 

2.  Savings  Departments  of  Commercial  Banks. 
Many  institutions,  especially  in  the  West,  combine 

both  saving  and  commercial  banking.  Sa\'ings  ileposits 
at  times  exceed  checking  accounts  in  amount,  but  as 
a  rule  these  banks  engage  essential!}^  in  commercial 
business  and  only  incidentally  oj^erate  a  sa\'ings  depart- 
ment. At  first  trust  companies  and  later  state  banks 
were  allowed  to  receive  savings  deposits  in  addition  to 

carrying   commercial   accounts.      National   banks   re- 
22 


328  BANKING  AND   BUSINESS 

frained  from  accepting  savings  deposits,  for  it  was 
believed  that  this  power  was  not  granted  under  the 
National  Bank  Act.  In  1903  the  Comptroller  of  the 
Currency  expressed  the  opinion  that  while  a  national 
bank  was  not  specifically  authorized  to  accept  time 
deposits,  nevertheless  this  step  was  not  expressly  pro- 
hibited by  the  National  Bank  Act.  The  question  was 
definitely  settled  in  favor  of  the  national  banks  by  the 
Federal  Reserve  Act,  which  recognizes  a  savings  depart- 
ment in  Section  19,  defining  deposits  as  follows:  "De- 
mand deposits  within  the  meaning  of  this  act  shall 
comprise  all  deposits  payable  within  thirty  days, 
and  time  deposits  shall  comprise  all  deposits  payable 
after  thirty  days,  all  savings  accounts  and  certificates 
of  deposit  which  are  subject  to  not  less  than  thirty  days' 
notice  before  payment."  This  definition  has  practically 
the  same  force  as  an  authorization  to  accept  savings 
deposits,  and  accordingly  many  national  banks  now 
operate  such  departments. 

3.  Guaranty-fund  Banks. 

Another  type  of  savings  institution  is  the  guaranty- 
fund  bank  which  prevails  in  New  Hampshire.  It  com- 
bines several  of  the  essential  features  both  of  the 
mutual  and  of  the  stock  banks.  In  common  with  the 
mutual  tj^De,  the  guaranty  bank  handles  no  commercial 
accounts  and  its  funds  are  derived  from  savings 
deposits.  The  distinctive  feature  of  the  guaranty 
bank  arises  from  the  division  of  its  deposits  into  general 
and  special.  The  general  deposits  bear  a  definite  rate 
of  interest,  and  therein  are  unlike  mutual  savings-bank 
accounts,  whose  yield  is  a  dividend  dependent  upon 
earnings.  After  interest  has  been  granted  on  the  gen- 
eral deposits  in  the  guaranty  bank,  the  remaining  sum 
is  paid  on  the  special  deposits.  These  serve  as  a 
guaranty  fund  for  the  general  deposits  in  the  event  of 


SAVINGS  INSTITUTIONS  329 

nonpa>Tnent  of  interest  or  principal.  In  return  for 
higher  earnings,  the  special  depositors  assume  a  pro- 
portionately greater  risk.  In  a  way,  general  deposits 
of  the  guaranty  bank  resemble  preferred  stock  of  a  cor- 
poration, and  special  deposits  may  be  compared  to 
comm.on  shares. 

4.  Co-operative  Associations. 

The  co-operative  savings  institutions,  such  as  build- 
ing-and-loan  associations  and  the  credit  union,  have 
been  described  in  Chapter  III. 

5.  Postal  Savings  System. 

The  postal  savings  system  aims  to  encourage  thrift 
}  >y  offering  a  secure  depository  for  savers  through  the 
mechanism  of  the  government  post  office.  This  was 
the  subject  of  active  discussion  following  the  close  of  the 
Civil  War,  and  met  with  considerable  opposition.  Pro- 
ponents of  postal  savings  believed  that  the  government 
post-office  stations  would  become  feeders  of  the  banks 
by  directing  pubHc  attention  to  the  importance  of 
thrift.  They  also  claimed  that  it  would  attract  funds 
ordinarily  hoarded  by  immigrants  and  others  through 
mistrust  of  privately  owned  banks.  This  contention 
received  added  strength  in  1907,  when  the  panic  caused 
heavy  withdrawal  of  savings  deposits. 

Finally,  in  1910  Congress  passed  the  Postal  Savings 
Act.  It  provides  for  a  board  of  trustees  consisting  of 
three  Cabinet  officers  (the  Postmaster-General,  Attor- 
ney-General, and  the  Secretary  of  the  Treasury).  They 
are  empowered  to  designate  post  offices  as  depositories 
of  savings,  and  in  general  to  administer  the  system. 
The  Act  regulates  deposits  rather  narrowly.  They  are 
to  be  received  from  individuals  alone,  and  only  one 
account  can  be  held  by  a  person  at  any  time.  At 
first  the  balance  was  limited  to  $500,  but  lat^er  the 


330  BANKING   AND   BUSINESS 

maximum  was  raised  to  S2,500.  A  saver  receives  not 
the  usual  pass  book,  but  a  certificate  of  deposit,  which 
is  nontransferable  and  nonnegotiable.  The  interest 
rate  on  all  deposits  was  fixed  at  2  per  cent,  thus  differ- 
ing from  the  principle  of  savings  banking,  which  varies 
the  rate  according  to  earnings.  These  savings  funds 
are  invested  in  United  States  government  securities  or 
redeposited  in  state  or  national  banks  paying  2\i  per 
cent  on  such  daily  balances  and  offering  satisfactory 
municipal  or  other  public  bonds  as  security. 

In  general,  the  total  postal  savings  deposits  have 
declined  and  many  of  the  offices  have  been  discon- 
tinued. One  cause  has  undoubtedly  been  the  low  rate 
of  2  per-cent,  which  has  not  appealed  to  savers  in  a 
period  of  rapidly  rising  interest  rates  and  high  yielding 
government  war  bonds.  The  lack  of  progress  of  the 
postal  savings  system  may  be  attributed  to  the  in- 
creased facilities  offered  by  the  growing  number  of 
savings  departments  in  national  banks. 

Postal  savings  banks  have  been  estabUshed  in  Eng- 
land, France,  Italy,  and  in  about  forty  other  countries. 
Elsewhere  in  Europe  pubhc  banks  have  been  conducted 
by  municipaUties.  In  Germany,  where  no  postal 
savings  system  exists,  banks  for  savings  are  operated 
by  almost  all  the  large  cities.  Local  governments  have 
not  entered  the  field  of  banking  in  the  United  States, 
where  a  more  restricted  theory  regarding  the  function 
of  the  municipality  is  held. 

Having  studied  the  various  forms  of  private  and 
public  savings  institutions,  it  is  e\'ident  that  not  all 
of  them  are  adapted  to  the  economic  conditions  existing 
in  the  United  States.  Pubhc  savings  banks,  whether 
federal  or  local,  have  made  little  or  no  progress.  Nor 
have  all  privately  owned  savings  institutions  flourished, 
for  no  rapid  advancement  has  been  made  either  by  the 
co-operative  associations  or  by  the  stock  savings  banks 


SAVINGS   INSTITUTIONS  331 

accepting  only  savings  (iep(3sits.  Progress  has  been 
shown  only  by  stock  banks  holding  both  commercial 
and  savings  accounts,  and  nonstock  or  mutual  banks 
receiving  only  savings  deposits.  AMiile  the  changing 
economic  conditions  since  1914  have  affected  the 
amount  of  these  savings  deposits,  they  were  consider- 
ably augmented  during  the  wave  of  prosperity  in  1919, 
and  they  were  not  impaired  by  the  depression  in  1920 
and  1921.  However,  savings  institutions  to-day  face 
certain  problems  which  will  be  briefly  considered. 

VII.  Recent  Developments  Among  Savings  Insti- 
tutions. 

There  is  an  ever-growing  competition  between  mutual 
savings  banks  and  commercial  banks  with  savings 
departments.  As  a  result  of  the  struggle  for  savings 
accounts,  the  interest  rate  has  often  been  forced  to  a 
high  level.  In  general,  commercial  banks  have  been 
able  to  outbid  the  mutual  savings  banks,  as  the  latter's 
investments  are  restricted  by  law  and  their  earnings 
consequently  limited.  It  must  also  be  remembered 
that  mutual  savings  banks  are  not  operated  for  profit; 
hence  trustees  at  times  lack  this  incentive  to  adopt 
methods  for  securing  new  business.  Nevertheless,  many 
of  the  mutual  banks  are  now  following  a  more  progres- 
sive poHcy  in  order  to  gather  new  accounts.  Such 
services  are  offered  as  the  holding  of  Liberty  Bonds  for 
persons  who  cannot  afford  to  rent  safe-deposit  boxes. 
In  Massachusetts,  some  savings  banks  conduct  insur- 
ance departments  for  the  issuing  of  policies.  Mutual 
banks  have  practically  waived  the  right  of  notice  before 
the  withdrawal  of  funds,  and  thus  savings  deposits 
are  virtually  payable  on  demand. 

In  order  to  meet  this  change  in  the  nature  of  sa\'ings 
deposits,  it  has  likewise  been  necessary  to  shorten  the 


332  BANKING  AND  BUSINESS 

maturity  of  certain  investments,  so  that  they  possess 
greater  liquidity.  It  has  even  been  propused  to  admit 
mutual  banks  to  membership  in  the  Federal  Reserve 
system.  This  plan  is  not  feasible,  since  mutual  banks 
have  no  capital  stock,  and  cannot  as  members  subscribe 
to  shares  in  the  Federal  Reserve  banks;  also,  as  they 
seldom  hold  eligible  paper,  they  cannot  well  take  advan- 
tage of  the  rediscount  faciUties. 


CHAPTER  XXI 
TRUST  COMPANIES 

I.  Nature  of  a  Trust. 

Before  considering  the  subject  of  trust  companies, 
it  is  necessary  first  to  understand  the  nature  of  a  trust. 
For  example,  A  surrenders  certain  property  to  B  with 
the  understanding  that  the  former  retains  full  benefit 
of  the  property,  while  the  latter  holds  a  kind  of  owner- 
ship over  it.  The  first  party  has  such  faith  that  he 
yields  the  title  of  his  property  over  to  the  second  party, 
who  in  consequence  assumes  an  obligation  which  is 
described  as  a  trust.  The  party  who  receives  the 
ownership  is  known  as  the  trustee,  and  the  giver  is 
called  the  trustor.  He  may  at  the  same  time  be  the 
beneficiary  who  derives  the  income  or  the  use  of  the 
property  in  trust.  More  usually,  the  beneficiary  is  a 
third  party — for  example,  a  son  for  whose  education 
the  father  creates  a  fund  to  be  administered  by 
some  friend  acting  as  trustee  in  accordance  with  the 
terms  of  a  formal  agreement.  This  illustration  indi- 
cates all  the  essential  parties  and  factoi-s  in  a  trust, 
namely:  beneficiary,  trustor,  trustee,  property  in 
trust,  and  statement  of  the  terms  under  which  this 
property  is  to  be  assigned,  administered  and  finally 
disposed. 

II.  Individual  and  Corporate  Trustees  Compared. 

There  are  individual  or  corporate  trusts,  depending 
upon  the  nature  of  the  trustors  who  have  created  them. 


334  BANKING  AND   BUSINESS 

Trustees  are  not  necessarily  real  persons,  for  corpora- 
tions may  be  designated  in  this  capacity.  In  fact,  there 
are  distinct  advantages  in  having  an  incorporated  or- 
ganization act  as  trustee.  As  a  chartered  body,  it  has  a 
continuous  existence  and  so  is  not  subject  to  the  uncer- 
tainties which  beset  the  life  of  an  individual.  A  person's 
financial  strength  is  inferior  to  that  of  the  corporation 
with  its  capital,  surplus,  and  other  resources.  Another 
element  of  greater  safety  lies  in  the  fact  that  the  cor- 
poration is  under  close  regulation  and  periodic  examina- 
tion by  the  state  which  grants  its  charter.  The  cor- 
porate trustee  can  also  offer  to  its  clients  the  benefits 
arising  from  the  economy  of  large-scale  business.  While 
an  individual  may  be  called  upon  to  act  as  trustee  only 
once  in  his  lifetime,  a  fiduciary  corporation  administers 
trusts  daily  and  so  accumulates  a  vast  fund  of  special- 
ized experience.  Because  of  the  volume  of  its  business, 
a  corporate  trustee  is  able  to  retain  the  services  of 
experts  in  investments,  law,  and  other  fields  of  technical 
knowledge.  The  judgment  of  a  corporation  in  dealing 
with  intricate  family  matters  will  not  likely  be  influ- 
enced by  personal  feelings  which'  may  affect  the  indi- 
vidual trustee.  However,  this  impersonal  nature  of 
the  corporation  may  at  times  prove  a  limitation  in 
administering  trusts  which  require  sympathetic  care. 
The  relative  merits  of  individual  and  corporate  trustees 
depend  largely  upon  the  nature  of  each  particular  trust, 
but  the  latter  is  generally  regarded  as  superior  because 
of  its  permanent  existence,  financial  strength,  govern- 
ment supervision,  large-scale  business,  and  speciafized 
staff. 

As  the  executing  of  trusts  involves  large  sums  of 
money,  it  is  quite  natural  for  a  trust  company  in  time 
to  develop  a  banking  business.  Conversely,  a  bank 
with  its  financial  strength  is  well  fitted  to  administer 
fiduciary  affairs.    So,  on  the  one  hand,  trust  companies 


TRUST  COMPANIES  335 

have  entered  the  field  of  banking,  while  banks  in  turn 
have  invaded  the  fiduciary  business  by  opening  trust 
departments.  This  chapter  will  consider  next  the 
development  of  these  movements,  then  the  administra- 
tion of  individual  and  corporate  trusts,  and  finally 
government  regulation  of  fiduciary  institutions. 

III.  Development  of  Trust  Companies. 

As  indicated  above,  the  essential  feature  of  a  trust  is 
the  separation  of  the  use  of  certain  property  from  its 
ownership  and  the  division  of  the  use  and  ownership 
between  two  different  parties.  This  concept  can  be 
traced  back  to  the  thirteenth  century,  when  the  decline 
of  the  feudal  system  was  vitally  affecting  the  legal  view 
of  property  rights  in  England  and  on  the  Continent. 
Although  trusts  have  existed  in  Europe  for  several 
centuries,  the  trust  company  is  a  distinctly  American 
institution,  and  its  history  covers  a  period  of  only  one 
hundred  years.  The  first  trust  com]mny  was  organized 
in  New  York  City  when  the  state  granted  a  charter  to 
the  Farmers'  Fire  Insurance  and  Loan  Company  (later 
the  Farmers'  Loan  and  Trust  Company) .  As  the  name 
implies,  this  corporation  was  engaged  primarily  in  the 
business  of  insurance,  but  under  its  charter  it  was  also 
permitted  to  execute  trusts.  Several  years  later  the 
New  York  Life  Insurance  and  Trust  Company  was 
incorporated  with  similar  powers.  Until  the  outbreak 
of  the  Civil  ^^^ar  not  more  than  half  a  dozen  trust  com- 
panies had  been  organized  in  the  United  States.  More- 
over, their  activities  were  limited  both  by  legal  and  by 
economic  conditions.  Trust  companies  were  usually 
prohibited  from  receiving  deposits  or  from  conducting 
any  other  form  of  banking  business.  It  must  also  be 
remembered  that  prior  to  the  Civil  War,  the  medium 
of  paying  business  obligations  was  not  the  check  drawn 


336  BANKING  AND  BUSINESS 

against  a  deposit  account,  but  the  note  issued  by  a 
bank.  This  operation  of  circulation  could  not  well  be 
conducted  by  a  trust  company.  Its  fiduciary  business 
was  confined  mainly  to  trusts  created  by  individuals, 
as  few  business  corporations  were  in  existence  before 
the  middle  of  the  century. 

After  the  Civil  War,  new  economic  conditions  exerted 
a  great  influence  over  the  nature  of  the  trust  company 
and  expanded  its  powers  considerably.  This  tendency 
is  well  represented  in  the  charter  of  the  Rhode  Island 
Hospital  Trust  Company,  which  was  permitted  to  exe- 
cute trusts,  accept  savings  deposits,  and  exercise  all 
banking  powers,  with  the  exception  of  issuing  notes  for 
circulation.  With  the  close  of  the  Reconstruction 
period  and  the  beginning  of  industrial  expansion  dur- 
ing the  last  quarter  of  the  nineteenth  century,  there 
was  a  rapid  accumulation  of  great  private  fortunes  and 
widespread  growth  of  large  corporations.  These  tend- 
encies resulted  in  widening  the  operations  of  trust 
companies,  which  now  conducted  safe-deposit  vaults 
for  storing  the  valuables  of  wealthy  individuals,  and 
opened  departments  for  rendering  financial  services  to 
corporations.  New  forms  of  trusts  were  created  mth 
the  development  of  corporate  finance  during  the  first 
decade  of  the  twentieth  century,  and  the  extraordinary 
conditions  arising  from  the  war  further  stimulated 
fiduciary  relations.  The  growth  of  trust  companies  in 
recent  years  is  evidenced  by  the  fact  that  the  combined 
resources  of  all  trust  companies  in  the  United  States 
amounted  to  $705,000,000  in  1895,  while,  in  1915,  their 
assets  amounted  to  $6,000,000,000,  and  by  the  middle 
of  1921  the  total  aggregated  $12,323,000,000. 

During  this  century  of  development,  the  operations  of 
trust  companies  have  been  considerably  changed.  In 
the  first  place,  their  original  insurance  business  was 
gradually  abandoned.    The  passing  of  these  operations 


TRUST   COMPANIES  337 

may  be  attributed  in  part  to  legislative  acts  which  pro- 
hibited trust  companies  from  writing  fidehty  poHcies. 
Moreover,  economic  tendencies  encouraged  the  growth 
of  corporations  speciaUzing  only  in  insurance.  With  the 
evolution  of  this  business,  it  was  soon  apparent  that  a 
concern  dealing  in  one  form,  such  as  life  insurance  or 
real-estate  title  insurance,  could  operate  more  inex- 
pensively than  a  corporation  which  attempted  to  carry 
all  classes  of  risks.  The  loss  of  this  insurance  business 
was  compensated  by  the  assumption  of  new  fiduciary 
powers,  including,  in  time,  the  administrating  of  cor- 
porate trusts.  In  addition,  trust  companies  received 
deposits,  granted  loans,  and  finally  exercised  general 
banking  powers.  In  consequence  the  modern  trust 
company  may  be  regarded  as  a  bank  which  exercises 
fiduciary  functions. 

IV.  Growth  of  Trust  Departments  of  Banks. 

As  trust  companies  entered  the  field  of  commercial 
banking,  they  came  into  direct  competition  with/ 
national  banks.  These  institutions  began  to  appreciate 
the  advantages  of  conducting  a  fiduciary  business 
which  yielded  profits  and  at  the  same  time  attracted 
customers  to  the  other  departments  of  the  bank.  Trust 
powers  were  not  directly  granted  by  federal  law,  but  a 
national  bank  was  able  to  overcome  this  omission  by 
purchasing  a  majority  interest  in  the  stock  of  a  trust 
company  incorporated  under  state  law.  This  tendency 
to  combine  commercial  banking  and  fiduciary  busi- 
ness was  given  official  sanction  by  the  Federal  Reserve 
Act,  which  in  Section  11-K  authorizes  the  Federal 
Reserve  Board  to  confer  certain  trust  powers  upon 
national  banks  applying  for  them.  This  counter  in- 
vasion by  the  national  banks  into  the  province  of  the 
trust  companies  stirred  vigorous  opposition.   The  ques- 


338  BANKING  AND   BUSINESS 

tion  arose  as  to  whether  the  Federal  Reserve  Board 
could  grant  national  banks  fiduciary  powers  if  these 
were  conferred  by  state  law  upon  trust  companies  only. 
After  consideration  by  state  judiciaries,  the  Supreme 
Court  of  the  United  States  declared  that  Congress  was 
fully  within  its  rights  in  granting  trust  powers  to  national 
banks.  However,  this  decision  recognized  a  state's 
prerogative  to  impose  upon  national  banks  exer- 
cising trust  powers  the  same  regulations  which  gov- 
erned local  corporations  engaged  in  this  business. 
Congress  accepted  this  view  and  incorporated  it  in  an 
amendment  to  the  Federal  Reserve  Act. 

It  has  been  observed  several  times  that  there  is  now 
little  difference  in  the  business  of  a  large  trust  company 
and  that  of  a  national  bank.  They  both  engage  in  com- 
mercial banking,  receive  savings  deposits,  operate  a 
bond  department  or  conduct  a  separate  investment 
company,  and  exercise  trust  functions.  The  nature 
of  commercial,  savings,  and  investment  banking  has 
been  already  considered,  and  fiduciary  business  alone 
remains  to  be  studied.  This  analysis  will  not  con- 
sider specifically  the  operation  of  either  a  trust 
company  or  the  fiduciary  department  of  a  national 
bank,  but  rather  will  examine  the  administration  of 
each  of  the  more  important  trusts,  whether  executed 
by  state  or  federal  institution. 

V.  Individual  Trusts. 

1.  Voluntary. 

A  trust  company  can  render  a  variety  of  service  to 
the  individual  during  his  lifetime,  and  to  his  estate 
after  his  death.  If  the  fiduciary  relation  is  effective 
while  the  individual  still  lives,  the  company  is  said  to 
act  as  trustee  under  deed  or  agreement  w^hich  creates 
what  is  called  a  voluntary,   or  personal,   trust.    A 


TRUST   COMPANIES  339 

testamentary  trust  designates  the  company  as  trustee 
under  will,  and  operates  only  after  the  death  of  the 
donor.  A  testamentary  trust  can  be  nulhfied  by  merely 
writing  a  new  will,  which  takes  precedence  over  the 
old  one. 

A  voluntary  trust  may  or  may  not  be  revocable  in 
form.  If  revocable,  the  creator  retains  the  right  at  any 
time  to  add  amendments  to  the  trust,  or  terminate  it 
altogether.  An  irrevocable  trust  is  placed  beyond  the 
l)ower  e\'en  of  the  maker  himself,  for  he  cannot  change 
the  provisions  unless  the  parties  interested  as  bene- 
ficiaries give  their  consent  to  an  alteration  or  cancella- 
tion. An  individual  can  create  a  trust  of  which  the 
beneficiary  may  be  an  institution,  another  third  party 
or  person,  or  even  the  trustee  himself. 

A  variety  of  conditions  may  induce  a  person  to 
assign  his  property  as  a  trust.  He  may  be  actively 
engaged  in  business,  and  therefore  without  sufficient 
time  to  care  for  the  detailed  administration  of  the 
property;  he  may  wish  to  retire  and  relieve  himself  of 
business  cares;  or  he  may  plan  to  travel,  and  during 
his  absence  his  financial  affairs  need  attention.  Under 
these  circumstances  the  owner  of  personal  property,  as 
stocks  and  bonds,  could  simply  place  them  in  a  vault 
for  safe  keeping.  But  such  property  requires  continual 
attention,  and  this  service  may  be  performed  by  a  trust 
company,  which  guarantees  not  only  the  physical  safety 
of  the  securities,  but  also  assures  proper  care,  such  as 
collection  of  dividends,  preparation  of  income-tax  state- 
ments, and  gathering  of  market  information.  The 
securities  may  be  sold  without  requiring  the  presence 
or  even  the  signature  of  the  owner,  if  he  transfers  the 
title  to  a  nominee,  who  is  usually  a  clerk  employed  by 
the  trust  company.  The  corporation  assumes  full  re- 
sponsibility for  the  actions  of  this  nominee,  who  has 
no  claim  to  actual  ownership.     This  legal  fiction  is 


340  BANKING  AND  BUSINESS 

quite  necessary  in  administering  these  trusts,  for  if 
the  securities  were  indorsed  in  the  name  of  the  com- 
pany a  special  authorization  of  its  board  of  directors 
would  be  required  for  each  sale. 

A  trust  company  also  manages  real  estate,  and  as 
agent  has  all  the  duties  and  rights  of  the  landlord  him- 
self. In  this  capacity  the  trust  company  pays  taxes 
and  insurance,  receives  rents,  and  grants  leases. 

The  beneficiary  of  a  trust  may  also  be  a  person  other 
than  the  trustor.  The  property  is  not  granted  as  a  gift, 
but  is  held  in  trust  for  the  recipient,  who  may  be  dis- 
quaUfied  from  outright  ownership  for  such  reasons  as 
inexperience  or  legal  incapacity.  Thus  provision  can 
be  made  for  the  education  of  a  child  or  the  support 
of  wife  or  other  dependent  relative  who  lacks  business 
knowledge.  A  trust  company  may  be  appointed  as 
guardian  of  a  minor,  or  conservator  for  an  insane 
person.  The  law  regards  such  persons  as  incompetent 
and  a  trust  company  may  conduct  their  affairs  until 
the  beneficiary  either  attains  his  full  age  or  regains  his 
reason. 

The  private  trusts  thus  described  continue  during  a 
definite  period  of  time,  or  indefinitely  until  the  occur- 
rence of  an  event  such  as  the  death  of  the  beneficiary. 
Only  public  trusts  can  be  created  in  perpetuity.  These 
charitable  trusts  are  estabhshed  for  the  benefit  of 
religious,  educational,  or  scientific  institutions.  In  this 
manner  a  trustor  provides  an  endo^\Tnent  for  foreign 
missions,  a  scholarship  in  a  university,  or  a  fellowship 
for  scientific  research. 

2.  Testamentary. 

A  trust  company  may  also  be  called  upon  to  adminis- 
ter a  testamentary  trust.  This  is  created  by  a  will, 
which  is  a  declaration  signed  by  the  testator  or  maker 
for  the  disposition  of  his  property  after  death.    The 


TRUST  COMPANIES  341 

provisions  of  the  will  are  carried  out  by  an  executor 
who  is  specified  in  the  will.  In  the  past  it  has  been  cus- 
tomary for  one  to  appoint  a  friend,  business  associate, 
or  counselor  as  his  executor,  but  there  is  a  growing 
practice  to  nominate  a  trust  company,  especially  for 
administering  large  estates.  The  executor  deposits  the 
will  in  the  surrogate's  court,  where  it  is  probated  or 
proved,  by  which  procedure  the  validity  of  the  ^^'ilI 
and  the  capacity  of  the  maker  are  tested.  If  the  sur- 
rogate is  satisfied  as  to  these  matters,  he  grants  the 
executor  a  legal  authorization  known  as  letters  testa- 
mentary. The  executor  then  appraises  or  evaluates  the 
property  of  the  deceased  and  files  an  inventory  with 
the  court.  All  claims  owing  to  the  deceased  are  col- 
lected, and  from  these  assets  all  obligations  against  the 
estate,  including  debts,  inheritance  taxes,  and  court 
expenses,  are  paid.  After  these  deductions  have  been 
made,  the  executor  distributes  the  remaining  property 
among  the  legatees  in  accordance  with  the  terms  of  the 
will.  A  complete  account  is  submitted  to  the  court, 
which  examines  it  and  then  discharges  the  executor. 
Should  the  deceased  fail  to  name  an  executor  in  his 
will  or  leave  no  such  instrument  at  all,  the  surrogate's 
court  then  appoints  an  administrator,  who  performs 
practically  the  same  duties  as  an  executor.  In  the  ab- 
sence of  a  will,  the  administrator  follows  the  state  law 
governing  the  disposition  of  property  of  persons  who 
die  intestate  or  without  a  will. 

VI.  Corporate  Trusts. 

1.  Member  or  Manager  of  an  Underwriting  Syndicate. 

From  the  above  description  of  the  more  important 
trusts  it  is  evident  that  a  fiduciary  company  can  serve 
the  individual  during  his  entire  period  of  life.  In  Hke 
manner,  a  corporation  can  be  aided  from  inception  to 


342  BANKING  AND   BUSINESS 

dissolution,  and  in  fact  many  of  the  problems  of  cor- 
porate finance  can  be  solved  only  with  the  aid  of  fidu- 
ciary institutions.  A  previous  chapter  has  indicated 
the  manner  in  which  a  new  corporation  is  launched 
through  the  efforts  of  an  underwriting  syndicate.  In 
this  group,  a  trust  company  frequently  participates  as 
member  when  its  banking  department  contributes 
funds,  or  as  manager  when  the  trust  department  directs 
the  entire  transaction. 

2.  Transfer  Agent. 

After  a  corporation  has  been  successfully  started, 
the  trust  company  may  act  as  general  fiscal  agent, 
rendering  all  kinds  of  financial  services  to  the  corpora- 
tion. The  trust  company  is  not  usually  given  general 
powers,  but  only  one  or  more  special  duties.  One  of 
these  special  functions  is  that  of  acting  as  transfer 
agent  for  a  corporation.  In  this  capacity  the  trust 
company  keeps  accurate  records  of  all  changes  in  owner- 
ship of  the  stock  resulting  from  sales  and  purchases. 
It  must  be  remembered  that  a  stock  certificate  is  merely 
an  evidence  of  the  ownership  of  a  certain  number  of 
shares  which  can  be  transferred  from  one  person  to 
another  only  by  entering  this  assignment  in  the  stock 
book  of  the  corporation.  The  certificate  itself  is  non- 
negotiable,  so  the  seller  surrenders  the  old  instrument 
and  in  its  place  the  buyer  receives  a  new  one.  Thus 
the  chief  duty  of  the  transfer  agent  is  to  assure  a  ''good 
delivery"  or  a  clear  title  to  the  purchaser  of  the  stock. 

3.  Registrar. 

As  securities  worth  hundreds  of  milhons  of  dollars 
change  hands  daily,  every  precaution  must  be  taken  to 
protect  the  holders.  The  New  York  Stock  Exchange 
has,  therefore,  ruled  that  every  certificate  of  a  listed 
security  issued  by  a  transfer  agent  shall  be  further 


TRUST   COMPANIES  343 

recorded  by  a  registrar.  His  particular  function  is  to 
certify  that  the  amount  of  stock  certificates  outstand- 
ing at  all  times  will  not  exceed  the  number  of  shares 
actually  authorized  and  issued  by  the  corporation. 
Since  the  registrar  should  act  as  a  check  upon  the 
transfer  agent,  the  Stock  Exchange  will  not  permit  the 
same  trust  company  to  serve  in  both  these  capacities 
for  any  one  corporation.  For  the  transferring  of  shares, 
it  is  not  always  essential  to  retain  the  services  of  an 
outside  agent,  and  if  there  is  no  active  trading  in  its 
stock  a  small  corporation  usually  handles  these  transfers 
in  its  own  office.  A  number  of  the  large  industrial  con- 
cerns whose  stocks  are  listed  on  the  Exchange  maintain 
their  o\\ti  transfer  agencies  in  New  York  City.  Although 
a  corporation  is  thus  permitted  to  act  as  its  own  trans- 
fer agent,  under  no  condition  may  it  serve  as  registrar 
of  the  stocks  which  it  has  issued. 

Such  safeguards  are  not  as  imperative  in  handling 
bonds.  Coupon  bonds  are  negotiable  merely  by  deliv- 
ery from  one  j>erson  to  the  other,  and  this  transaction 
is  not  recorded  on  the  books  of  the  corporation  which 
has  originally  issued  the  securities.  However,  a  regis- 
tered bond  is  similar  to  a  stock  in  that  its  ownership 
can  be  changed  only  by  proper  entry  on  the  books  of 
the  corporation.  It  is  unnecessary  to  issue  a  new 
instrument  whenever  a  bond  changes  ownership,  for 
the  name  of  the  holder,  the  date  of  the  registration,  and 
the  signature  of  the  individual  acting  for  the  registrar 
appear  on  the  reverse  side,  and  so  a  separate  transfer 
agent  is  not  needed  in  the  assignment  of  the  bond. 

4.  Trustee  under  Corporate  Mortgage. 

Probably  the  most  important  single  trust  arises  when 
a  corporation  borrows  money  for  a  long  period  of  time 
and  pledges  some  of  its  property  as  collateral.  The  cor- 
poration, like  the  individual  borrowing  on  real  estate, 


344  BANKING  AND  BUSINESS 

must  sign  a  mortgage  by  which  the  title  over  certain 
property  is  temporarily  relinquished.  In  the  case  of  a 
small  loan  the  borrower  can  give  his  promissory  note 
and  the  mortgage  paper  directly  to  the  lender,  but  a 
large  corporation  needs  sums  so  great  that  they  caimot 
be  obtained  from  any  one  source,  but  must  be  gathered 
from  a  number  of  investors.  So  in  place  of  one  promis- 
sory note,  the  corporation  issues  bonds  each  represent- 
ing a  part  of  the  debt.  Obviously  the  mortgage  cannot 
be  divided  into  separate  instruments  for  distribution 
among  the  lenders,  and  it  must  be  surrendered  to  one 
party.  In  the  early  days  of  corporate  financing,  it  was 
customary  to  intrust  the  holding  of  this  mortgage  to 
one  of  the  larger  investors,  but  in  recent  years  this 
service  has  been  performed  by  a  trust  company,  which 
is  then  said  to  act  as  "trustee  under  corporate 
mortgage." 

The  nature  of  this  trust  may  best  be  understood  by 
describing  the  procedure  in  which  it  is  actually  handled. 
The  directors  of  a  railroad  seek  funds  for  undertaking 
permanent  improvements  on  the  line,  and  therefore 
vote  to  place  a  mortgage  on  part  of  their  property,  to 
which  proposal  the  stockholders  give  approval.  After 
all  the  details  have  been  decided  upon,  the  company's 
attorneys  then  prepare  a  mortgage  indenture,  or  con- 
tract. This  instrument  contains  a  detailed  description 
of  the  property  which  is  being  hypothecated.  It  may 
consist  of  real  estate  such  as  terminals  and  tracks. 
When  equipment  such  as  rolling  stock  is  pledged,  this 
property  forms  the  basis  of  what  is  known  as  an  "equip- 
ment trust."  A  third  form  of  security  is  the  ''col- 
lateral" trust,  which  consists  of  personal  property, 
such  as  stocks  or  bonds  of  railroads  controlled  by  the 
corporation  making  the  loan,  or  general  securities 
owned  by  the  corporation. 

The  mortgage  indenture  also  defines  the  relations 


TRUST   COMPANIES  345 

among  the  parties  concerned.  In  the  case  of  physical 
equipment  the  railroad  company  is  allowed  to  retain 
physical  possession  of  the  property,  for  it  must  con- 
tinue to  use  the  terminals  and  to  operate  the  trains. 
The  legal  title  to  all  this  property  is  conveyed  to  the 
company  acting  as  trustee,  which  holds  it  in  behalf  of 
the  bondholders.  The  mortgage  with  these  proWsions 
is  then  submitted  to  the  trust  company.  All  the  cove- 
nants or  stipulations  are  carefully  examined,  and  if 
they  are  satisfactory  the  company  executes  or  signs  the 
mortgage  and  thus  acknowledges  its  acceptance  of  the 
trust.  It  then  records  the  mortgage  in  the  public 
office  of  the  secretary  of  the  state  where  the  property 
is  located.  The  bonds  are  delivered  to  the  trustee  for 
authentication,  by  which  procedure  the  trustee  com- 
pares the  bonds  with  the  provisions  of  the  indenture, 
to  prevent  the  corporation  from  issuing  securities  either 
in  excess  of  the  amount  authorized  or  contrary  to  the 
terms  of  the  mortgage.  When  the  trustee  has  verified 
the  validity  of  the  bonds,  they  are  then  returned  to  the 
issuing  corporation. 

Provision  is  sometimes  made  during  the  life  of  the 
mortgage  for  its  gradual  amortization,  so  that  the  pay- 
ment of  the  outstanding  principal  is  distributed  in 
installments  over  the  entire  period  instead  of  remaining 
at  the  full  amount  on  maturity.  The  corporation  does 
this  by  giving  the  trustee  a  certain  sum  periodically 
as  a  sinking  fund  to  retire  a  portion  of  the  bonds. 
Whether  or  not  a  sinking  fund  is  provided,  the  entire 
issue  is  finally  retired  at  the  expiration  of  the  loan,  and 
the  trust  company  destroys  the  certificates.  When  the 
claims  of  the  bondholders  as  to  dividends  and  principal 
have  been  fully  settled,  the  trust  comjiany  returns  the 
legal  title  of  the  property  to  the  railroad.  If,  on  the 
other  hand,  the  borrowing  corporation  defaults  in  the 
payment  of  either  interest  or  principal,  or  fails  in  com- 


346  BANKING  AND   BUSINESS 

plying  with  any  other  terms  of  the  mortgage,  the  trust 
company  must  then  assume  certain  obhgations.  Al- 
though the  trust  company  has  under  no  condition 
guaranteed  the  value  of  the  bonds,  it  is  nevertheless 
expected  to  take  every  measure  possible  to  protect  the 
security  holders.  If  the  borrowing  corporation  fails  to 
observe  the  provisions  of  the  mortgage,  it  is  the  duty 
of  the  trustee  to  foreclose  the  mortgage  and  to  have 
the  property  sold  for  the  benefit  of  creditors  in  a  manner 
already  described  in  connection  with  an  ordinary  lien 
on  a  house. 

5.  Depository  under  Reorganization  Agreement. 

A  foreclosure  against  a  railway  company  presents  an 
added  problem,  for  even  during  these  proceedings  the 
road  must  continue  in  operation  in  the  interest  of  the 
pubhc  which  uses  the  system,  and  also  for  the  benefit 
of  the  bondholders  who  wish  to  recover  their  money. 
In  this  situation  it  is  customary  to  form  a  committee 
of  the  principal  security  holders  whose  personal  stand- 
ing will  inspire  confidence.  This  group  drafts  plans 
for  the  rehabilitation  of  the  defaulted  railroad,  and  as 
a  first  step  requests  all  holders  of  securities  to  surrender 
them  to  a  trust  company  which  is  designated  as 
''depository  under  reorganization  agreement."  In 
administering  this  trust,  the  fiduciary  company  is  really 
acting  as  stakeholder  or,  in  the  legal  term,  as  agent  in 
"escrow."  This  has  been  defined  as  an  "instrument 
placed  by  a  grantor  in  the  hands  of  a  third  party  to  be 
delivered  to  a  grantee  upon  the  fulfillment  by  the 
latter  of  a  certain  specified  condition."  In  the  class  of 
escrow  being  now  considered,  the  grantors,  or  the 
owners  of  the  defaulted  securities,  place  them  in  the 
custody  of  the  trust  company,  which  in  turn  surrenders 
them  to  the  members  of  the  reorganization  committee 
as  grantees.    The  trust  company  gives  the  owners  tern- 


TRUST  COMPANIES  347 

porary  receipts  for  their  securities  and  later,  in  a  man- 
ner quite  similar  to  the  transferring  and  registering  of 
original  bonds,  formal  instruments  known  as  certifi- 
cates of  deposit.  If  the  work  of  reorganization  is  suc- 
cessfully performed,  the  trust  company  calls  for  the 
return  of  the  certificates  of  deposit  and,  in  exchange, 
issues  new  securities.  At  times  it  may  be  good  pohcy 
to  merge  the  railway  with  a  stronger  road,  and  then 
the  trust  company  acts  as  depository  of  the  securities 
under  a  plan  of  consolidation. 

6.  Assignee  and  Receiver. 

If  the  finances  of  the  railroad  continue  in  a  critical 
condition,  the  stockholders  to  protect  their  property, 
or  the  creditors  to  guard  their  interests,  may  appoint 
a  trust  company  as  assignee.  Under  the  deed  of  assign- 
ment, the  trust  company  collects  the  debts  due  to  the 
railroad  and  as  far  as  possible  pays  the  claims  of  the 
creditors.  Creditors  are  sometimes  forced  to  press  their 
claims  before  a  court,  which  then  places  the  corporation 
in  the  hands  of  a  receiver.  While  his  duties  are 
similar  to  that  of  the  assignee,  they  are  Umited  to  the 
objects  specified  in  the  terms  of  the  apphcation  of  the 
creditors  and  the  orders  of  the  court.  The  main  pur- 
pose of  a  reorganization  committee,  assignee,  or  receiver 
is  to  assist  the  embarrassed  corporation  out  of  its 
difficulties  and  if  possible  restore  it  to  pajdng  basis. 

A  definite  division  of  trusts  cannot  well  be  made, 
for  some  forms  may  be  both  individual  and  corporate. 
In  the  above  analysis,  a  trust  company  was  viewed  as 
custodian  of  the  securities  of  an  individual,  but  the 
same  service  may  also  be  rendered  for  a  corporation. 
Conversely,  a  trust  company  may  act  as  agent  in 
escrow,  assignee,  or  receiver  for  an  individual  as  well  as 
for  a  corporation.  In  general,  the  distinctly  individual 
trusts  are  those  of  guardian,  conser\ator,  executor,  and 


348  BANKING  AND  BUSINESS 

administrator,  while  underwriting  manager,  transfer 
agent,  and  registrar  are  the  exclusively  corporate 
fiduciary  relationships. 

VII.  Regulation  of  Fiduciary  Institutions. 

It  is  evident  from  this  survey  of  the  nature  of  trusts 
that  fiduciary  business  differs  from  commercial  banking 
in  respect  to  fundamental  principles  and  technical 
operations.  It  is  apparent  that  the  legal  and  personal 
relation  between  the  trust  company  and  the  trustor, 
or  beneficiary,  is  not  merely  one  of  debtor  and  creditor 
as  exists  between  a  bank  and  an  ordinary  depositor. 
These  differences  are  fully  recognized  in  state  laws  and 
federal  rulings  which  subject  fiduciary  institutions  to 
separate  regulations.  In  conclusion,  consideration  will 
be  given  to  the  content  of  this  legislation  and  its  under- 
lying principles.  Federal  and  state  regulations  will 
not  be  differentiated  in  this  analysis,  since  the  former 
to  a  large  degree  are  based  on  the  latter,  and,  more- 
over, the  Federal  Reserve  Board  has  ruled  that  a 
national  bank  which  assumes  trust  powers  must  exer- 
cise them  in  conformity  with  the  laws  of  the  state  in 
which  it  is  located. 

For  the  protection  of  certain  classes  of  trusts,  a 
fiduciary  institution  is  often  required  to  deposit  special 
securities  with  the  state  Superintendent  of  Banking. 
At  times,  a  trust  company  is  compelled  to  execute  a 
bond  as  guaranty  that  it  will  act  in  good  faith.  In 
addition  to  these  requirements,  fiduciary  institutions 
must  usually  meet  certain  requirements  of  the  capital 
and  surplus,  which  are  often  higher  than  those  de- 
manded of  commercial  banks.  Government  examina- 
tions are  made  periodically,  and  national  banks  are 
thus  under  the  scrutiny  of  both  federal  and  state  officers. 

An  institution  conducting  a  fiduciary  and  banking 


TRUST  COMPANIES  349 

business  must  maintain  a  distinct  and  separate  set  of 
records  for  its  trust  business.  Limitations  are  also 
placed  on  the  manner  in  which  a  fiduciary  institution 
may  invest  the  funds  which  have  been  intrusted  to  it. 
If  the  will  or  deed  creating  the  trust  definitely  describes 
the  particular  security  in  which  the  fund  is  to  be  placed, 
this  stipulation  must  be  strictly  observed  by  the 
trustee.  But  the  creator  of  a  trust  does  not  always 
define  the  exact  character  of  the  investment  and  leaves 
this  matter  to  the  discretion  of  the  bank  directors, 
who  are  then  expected  to  exercise  due  diligence  in  their 
selection.  When  the  form  of  the  investment  is  not 
specified  at  all,  the  state  law  usually  describes  the 
eligible  classes.  In  New  York  State,  trust  funds  may 
be  invested  only  in  those  securities  which  are  legal  for 
purchase  by  the  mutual  savings  banks. 


Part  IV 
THE  BANKING  SYSTEM 


CHAPTER   XXII 

TYPES  OF   BANKING   SYSTEMS 

I.  Banking  Systems  Grouped  According   to   Or- 
ganization. 

From  what  has  been  said  in  the  foregoing  chapters  it 
will  have  been  seen  that  banking  experience  in  the  dif- 
ferent countries  of  the  world  has  evolved  several  types 
of  banking  systems.  Writers  on  banking  sometimes 
speak  as  if  there  were  one  kind  or  character  of  banking 
system  which  is  more  "scientific"  than  another,  or  as  if 
the  evolution  of  banking  had  pointed  definitely  to  some 
single  type  of  organization  which  was  regarded  as  the 
most  desirable  or  perfect.  Much  of  this  kind  of  sug- 
gestion has  often  been  given  to  the  pubhc  in  the  course 
of  banking  "refonn"  or  monetary  ''education"  move- 
ments. There  is  no  foundation  for  the  supposition 
that  one  kind  of  banking  organization  is  necessarily 
better  than  another.  Banking,  like  other  phases  of 
business  organization,  is  closely  related  to  the  business 
community  in  which  it  exists,  and  depends  much  for 
its  efficiency  and  success  upon  its  adaptation  to  local 
customs.  It  is  not  even  true  that  the  so-called  banking 
principles  relating  to  Uquidity,  short-term  loans,  re- 
serves, etc.,  have  any  universal  force.  They  depend 
entirely  upon  the  general  conditions  upon  which  banks 
operate,  the  demands  of  the  community  in  which  they 
are  situated,  and  other  factors.  So,  in  developing  a 
system  of  banking  the  essential  test  of  its  satisfactori- 
ness  is  found  in  adaptation  to  conditions.     It  is,  there- 


354  BANKING  AND   BUSINESS 

fore,  true  that  banking  systems  throughout  the  world 
differ  very  widely  from  one  another,  and  they  must  be 
judged  by  their  adaptability  and  success  in  practice. 

From  a  broad  general  standpoint,  however,  it  is  pos- 
sible to  recognize  several  types  of  banking  systems. 
Looked  at  from  the  point  of  view  of  the  legal  basis  or 
status  in  the  matter  of  organization,  three  chief  groups 
may  be  recognized,  as  follows : 

(1)  The  central  banking  systems,  of  which  the  banks 
of  England,  France,  and  others  of  similar  kind  are  the 
best  examples; 

(2)  The  independent-charter  banking  systems,  of 
which  the  Canadian  bank  is  probably  the  best  known; 
and 

(3)  The  free  banking  systems,  best  represented  by 
the  national  banking  system  of  the  United  States. 


II.  Central  Banking  System  of  Great  Britain. 

In  the  case  of  the  central  banking  systems  there  has 
been  developed  a  nucleus  which  represents  practically 
the  combined  banking  strength  or  the  pooling  of  bank 
reserves  of  the  community.  Other  banks  are  then  off- 
shoots from  such  an  institution,  such  as  the  Bank  of 
England,  not  in  the  sense  that  they  are  owned  or 
directed  by  it,  but  simply  in  that  they  look  to  it  for 
guidance  and  direction,  shape  their  policies  in  accord- 
ance with  its  doings  more  or  less,  and  count  upon  its 
aid  under  certain  given  conditions.  Before  the  opening 
of  the  European  War  it  was  believed  that  the  British 
banking  system  was  perhaps  the  best  type  of  organiza- 
tion. That  banking  system  included  a  number  of 
large,  strong  institutions  organized  for  the  perfonnance 
of  regular  commercial  banking  operations  in  England. 
These  banks  had  themselves  in  many  cases  been  de- 


TYPES  OF  BANKING  SYSTEMS     355 

veloped  out  of  a  considerable  number  of  other  banks, 
so  that  each  of  them  represented  a  pooHng  of  interests. 
Each  such  bank  had  a  considerable  number  of  branches 
scattered  throughout  the  United  Kingdom,  while  the 
main  office  of  each  was  in  London.  The  Bank  of 
England  was  thus  surrounded  by  a  group  of  strong 
commercial  institutions.  At  other  points  in  the 
United  Kingdom  were  situated  the  headc^uarters  of 
other  banking  systems.  Thus  in  Scotland  and  Ireland 
independently  organized  institutions  existed,  each  with 
its  set  of  branches,  and  such  banks  usually  had  a 
branch  in  London  for  the  purpose  of  transacting  busi- 
ness with  the  Bank  of  England  or  of  participating  in 
the  general  financial  market  at  that  place.  In  all, 
there  were  in  the  United  Kingdom  probably  about 
ninety  banks  with  interlacing  systems  of  branches;  but 
the  whole  banking  structure  was  practically  dominated 
by  a  few  strong  banks  \nth.  headquarters  in  London,  to 
which  reference  has  already  been  made.  The  Bank  of 
England,  as  the  result  of  long  practice  and  custom,  was 
the  holder  of  the  bulk  of  the  reserves  of  these  banks. 
At  times  before  the  war  the  bulk  of  the  cash  held  by 
the  banks  fell  as  low  as  3  or  4  per  cent  of  outstand- 
ing UabiUties,  and  various  banking  authorities  were 
inchned  to  view  this  "v^ith  some  alarm.  The  Bank 
of  England,  however,  by  maintaining  a  strong  reserve 
and  a  liquid  portfolio,  kept  itself  in  position  constantly 
to  meet  the  demands  of  the  other  banks,  and  conse- 
quently no  British  bank  which  was  in  possession  of 
paper  eligible  for  discount  or  salable  in  the  open  market 
was  ever  without  the  means  of  providing  cash  with 
which  to  meet  the  demands  of  its  depositors.  During 
the  war,  as  elsewhere  observed,  there  was  a  change  in 
this  state  of  affairs,  the  British  banks  amalgamating 
into  a  still  smaller  number  of  institutions.  Confining 
attention,  however,  to  the  prewar  situation,  we  may 


356  BANKING  AND  BUSINESS 

say  that  the  British  banking  system  was  practically 
a  pure  central  bank  organization. 

III.  Independent  -  charter    System     of     British 
Colonies. 

As  contrasted  with  this  highly  centralized,  highly 
organized  banking  system  of  Great  Britain,  attention 
may  be  given  to  the  colonial  systems  of  banking,  of 
which  those  of  Canada  and  Australia  are  good  ex- 
amples. In  each  of  these  countries  there  has  been 
organized  a  relatively  small  number  of  banking  estab- 
hshments.  In  some  instances  colonial  banks  have  been 
created  under  a  general  incorporation  law  Uke  our 
National  Bank  Act,  but  subject  to  restrictions  which 
kept  the  number  of  such  banks  very  small.  In  others 
the  banks  were  created  through  special  charter  which 
authorized  the  establishment  of  a  banking  institution 
vested  wdth  speciiied  duties  and  powers.  Whichever 
plan  was  followed,  the  result  was  practically  the  same 
in  that  the  outcome  w^as  the  creation  of  a  compara- 
tively small  number  of  powerful  institutions  which 
directed  interlacing  networks  of  branches  throughout 
the  territory  in  which  they  were  organized.  Thus, 
under  the  Canadian  banking  system,  thousands  of 
branches  scattered  throughout  the  Western  states 
gave  to  the  population  of  Canada  practically  as  many 
actually  open  or  available  banking  ofiices  as  have  been 
developed  in  the  United  States  under  the  plan  of  incor- 
porating independent  banks.  The  result  of  the  system 
was  to  establish  a  small  banking  community.  In 
Canada  the  total  number  of  banks  is  seventeen 
at  the  present  time,  and  has  seldom  been  much  over 
thirty.  In  Australia  to-day  about  twenty-five  banks 
exist,  and,  although  some  of  them  have  their  head- 
quarters in  London,  the  majority  are  locally  incor- 


TYPES  OF  BANKING   SYSTEMS     357 

porated.  Unity  of  action  in  banking  is  obtained  in 
each  country  through  informal  conmiunications  be- 
tween the  managers  of  the  different  banks  or  through 
action  of  the  bankers'  clearing  house,  which  operates 
as  a  kind  of  combination  or  pooling  of  interests  for  the 
nation  as  a  whole.  WTiile  there  is  no  central  bank  of 
rediscount,  each  bank  is  in  itself  sufficiently  strong  to 
exercise,  mider  good  management,  many  of  the  func- 
tions of  a  central  bank,  or  in  cases  where  material  aid 
is  needed,  it  may  be  obtained  through  interbank 
rediscounting  or  sale  of  bills  on  a  considerable  scale. 
In  Canada,  an  element  of  centralization  has  been  super- 
imposed through  the  creation  of  a  joint  guaranty  fund 
held  by  the  govermnent  and  designed  for  the  purpose 
of  paying  ofif  the  notes  of  any  bank  which  may  happen 
to  fail.  In  Australia,  centralization  is  in  a  measure 
obtained  through  the  recent  creation  of  the  Common- 
wealth Bank  of  Australia,  operated  by  the  government 
and  holding  its  deposits.  The  Commonwealth  has, 
however,  tended  to  be  a  bank  among  banks,  and  has 
never  attained  the  pre-eminence  of  the  Bank  of  England 
in  Great  Britain  as  a  bankers'  bank. 

Taking  the  Canadian  and  Austrahan  systems  as 
types,  therefore,  they  may  be  regarded  as  representa- 
tive of  a  fairly  well  integrated  and  developed  banking 
system.  Their  characteristic  feature  is  seen  in  the 
application  of  what  amounts  to  centralized  control 
through  a  community  of  interest,  moderately  supple- 
mented, as  in  the  case  of  Canada,  by  some  special 
features  of  public  intervention  or  participation.  No- 
where, however,  in  the  British  colonics  has  more  than 
sporadic  progress  been  made  toward  the  establishment 
of  a  positive  and  direct  governmental  control  over  the 
banking  system.  The  indirect  control  sought  to  be 
applied  in  some  countries  like  Australia,  through  the 
chartering  of  a  governmental  institution,  has  thus  far 


358  BANKING  AND  BUSINESS 

been  only  partially  successful,  and  its  future  may  be 
regarded  as  still  to  be  determined. 

IV.  Free  Banking  System  of  the  United  States. 

In  the  United  States  under  the  national  banking 
system  the  idea  of  free  banking  was  carried  to  its 
extreme  not  only  through  the  unrestrained  chartering 
of  institutions  with  very  small  capital  (the  mini- 
mum being  made  in  1900  as  low  as  $25,000),  but  also 
through  the  prohibition  of  the  establishment  of 
branches.  Inability  to  create  branches  consequently 
implied  the  necessity  of  creating  many  small  institu- 
tions, with  the  result  that  in  the  United  States  to-day 
the  total  number  of  banks  is  roundly  stated  as  30,000. 
These  banks  are  of  all  grades  of  size,  efficiency,  manage- 
ment, and  types  of  business,  and  even  in  the  national 
banking  system,  numbering  but  8,000  members,  all  of 
which  operate  under  some  uniform  standards  of  super- 
vision, owing  to  the  fact  that  they  are  obedient  to  the 
dictates  of  a  single  statute,  several  different  kinds  of 
banks  must  be  recognized.  Taking  the  t^^Dical  New 
York  City  or  Chicago  institution,  we  may  regard  it  as 
practically  on  a  plane  with  the  English  joint-stock 
banks  or  with  the  chartered  Canadian  or  Austrahan 
banks.  It  is  an  institution  of  large  capital,  broad  rami- 
fications, and  highly  advanced  methods  of  business. 
Were  it  permitted  to  estabUsh  branches,  it  would 
undoubtedly  do  so,  placing  them  at  strategic  points 
throughout  the  country  and  eventually  building  up  a 
network  of  communications  similar  to  those  existing  in 
Canada  or  in  Europe.  On  the  other  hand,  the  small 
country  bank  of  $25,000  capital  has  few  connections 
outside  of  its  own  conununity,  and  these  only  vdih. 
larger  banks  which  act  as  agents  for  it  in  the  holding 
of  its  funds  and  in  providing  remittances.    Such  banks 


TYPES  OF   BANKING   SYSTEMS     359 

are  to  be  regarded  as  analogous  to  the  branches  of  the 
great  European  and  Canadian  institutions  which  are 
estabhshed  here  and  there  merely  for  the  sake  of  meet- 
ing the  convenience  of  the  community. 

There  has  always  been  much  discussion  about  the 
question  what  type  of  banking  system  is  the  best 
or  the  most  scientific — a  problem  referred  to  at  the 
opening  of  the  present  chapter.  This  controversy  has 
reduced  itself  to  several  distinct  phases  which  may  be 
grouped  as  the  discussion  about  central  banking  or  the 
desirability  of  a  central  bank,  the  desirabihty  of  branch 
banking,  and  the  question  of  interlocking  directorates 
or  interbank  control.  Some  attention  ought  to  be 
given  to  each  pf  these  topics  by  every  student  of  bank- 
ing evolution,  since  a  comparison  of  ideas  relating  to 
them  throws  much  light  upon  the  question  of  types  of 
banking  systems.  In  practically  every  industry  to-day 
there  is  a  process  of  integration — that  is  to  say,  a 
process  of  classification  and  organization  which  results 
in  the  establishment  of  definite  units  of  business.  This 
is  true  in  banking  as  in  other  industries;  in  fact,  it  is 
probably  more  broadly  true  in  banking  than  elsewhere, 
owing  to  the  fact  that  banking  is  so  highly  developed 
and  systematized  as  an  occupation.  This  process  of 
integration  in  practically  every  industry  works  toward 
the  standardizing  of  products,  the  establishment  of 
narrower  margins  of  fluctuation  in  prices,  and  the 
creation  of  methods  of  insuring  community  of  action 
and  unity  of  control  throughout  the  industry. 

V.  Movement  Toward  Centralization. 

Everywhere  in  banking  there  is  a  movement  toward 
what  is  called  centralization,  not  in  the  sense  of  auto- 
cratic control  or  monoi)olistic  price  fixing,  but  merely 
in  the  sense  of  economy  of  resources  and  elimination  of 

24 


360  BANKING  AND   BUSINESS 

risk.  The  different  types  of  banking  systems  to  which 
reference  has  already  been  made  are  merely  different 
methods  or  plans  of  controlling  the  legal  and  economic 
organization  of  banks,  and  experience  under  them  has 
shaped  their  development  accordingly.  The  centraHz- 
ing  movement  to  which  reference  has  just  been  made 
is  seen  in  the  central  banks  of  England  and  France,  but 
is  also  seen  in  the  decreasing  number  of  Canadian 
banks,  and,  before  the  establishment  of  the  Federal 
Reserve  system,  was  reflected  in  the  increasing  amount 
of  interbank  control  which  resulted  in  giving  to  large 
banks  in  the  cities  power  over  many  smaller  institutions 
throughout  the  country.  These  tendencies  were  the 
outgrowth  of  a  desire  or  necessity  for  unity  of  action, 
of  interest  rate,  and  of  other  poUcies.  In  the  British 
banking  system  centralization  was  obtained  as  the 
result  of  custom  and  the  placing  of  funds  in  the  hands 
of  a  single  institution  which  was  regarded  as  best  able 
to  safeguard  them.  In  the  Canadian  banking  system 
the  unity  of  action  and  pohcy  was  obtained  through 
the  constant  narrowing  of  the  number  of  institutions 
themselves,  the  fact  that  they  and  their  home  offices 
were  in  constant  conmiunication  with  one  another  and 
that  an  informal  organization  had  been  established  to 
include  them. 

In  the  United  States  a  similar  result  was  obtained 
prior  to  1902  through  the  work  of  our  clearing  houses, 
through  the  development  of  systems  of  correspondents 
ramifying  throughout  the  country,  and  in  various  other 
ways.  The  question  whether  a  central  bank  was 
desirable  was  thus  a  mere  question  of  detail  of  manage- 
ment. In  some  countries  it  had  been  found  expedient 
to  create  such  a  central  bank  and,  as  in  England,  such 
a  bank  had  been  successful  in  controlling  the  general 
financial  situation  upon  an  equitable  basis  viithout  the 
aid  of  any  legislation.    In  other  countries  it  had  been 


TYPES  OF  BANKING  SYSTEMS     361 

deemed  wise  not  to  create  a  formal  organization  for  the 
oversight  of  banking,  but  to  leave  matters  to  develop 
on  a  semi-competitive  basis  in  the  belief  that  the  com- 
munity of  interest  would  exert  itself  so  far  as  was 
necessary,  and  that  it  was  not  wise  to  give  to  this  com- 
munity of  interest  any  definitely  organized  form.  The 
banking  systems  of  the  several  countries  to  which  refer- 
ence has  been  made,  may  thus  be  regarded  as  belonging 
to  different  grades  or  lines  of  development  rather  than 
to  different  types  of  banking.  In  every  country  bank- 
ing method  is  to-day  substantially  similar,  although 
details  may  differ  widely,  and  interbank  relationship  is, 
as  has  already  once  or  twice  been  stated,  largely  a 
matter  of  organization. 

VI.     Banking   Systems    Classified    According    to 
Operation. 

A  problem  which  should  be  considered  as  distinctly 
associated  with  this  matter  of  type  of  banking  system 
is,  however,  that  of  the  discount  market.  In  studying 
the  discount  market  we  are  in  position  to  pass  bej'ond 
the  view  of  banking  organization,  which  regards  it  as 
merely  a  matter  of  law  or  technic,  and  to  analyze  a 
much  more  fundamental  problem  in  connection  with 
banking  evolution.  This  is  the  scope  of  operations  of 
the  bank.  Here  we  may  Ukewise  recognize  some  three 
distinct  types  or  styles  of  banking  system,  as  follows: 

(1)  The  heterogeneous  banking  system  in  which  a 
bank  is  authorized  to  perform  practically  any  kind  of 
business  that  it  may  choose; 

(2)  The  specialized  banking  system  in  which  dif- 
ferent kinds  or  types  of  institutions  are  recognized  and 
are  defined  by  law; 

(3)  The  organized  banking  system  in   which   the 


362  BANKING  AND  BUSINESS 

different  classes  or  groups  of  banks  are  definitely 
related  to  one  another  and  are  given  a  specified  claim 
upon  or  connection  with  one  another. 

VII.  Heterogeneous  Banking. 

We  may  look  first  at  the  early,  primitive  type  of 
heterogeneous  banking  institution  in  which  there  was 
practically  httle  or  no  limitation  of  function.  The 
banks  of  the  early  modern  period  in  Europe  were  of  this 
variety.  They  loaned  upon  real  estate,  took  personal 
property  in  pledge,  issued  notes,  accepted  foreign  coin 
or  bullion  and  held  it  on  deposit,  eventually  issuing 
credits  which  took  the  form  of  deposit  accounts,  and 
also  did  more  or  less  of  a  real-estate  and  mortgage 
business.  As  time  went  on  it  was  seen  that  good  bank- 
ing called  for  a  differentiation  of  function,  and  that  the 
best  results  were  obtained  either  by  departmentalizing 
banks  and  keeping  their  various  activities  separate  one 
from  another,  or  else  by  creating  different  kinds  of 
institutions,  each  of  which  was  quahfied  to  perform  a 
special  function  or  duty.  Thus  in  British  banking  a 
sharp  distinction  came  to  be  drawn  at  an  early  date 
between  the  commercial  bank  which  dealt  only  in  very 
short-term  live  paper,  and  the  institution  which  under- 
took corporate  financing,  promoting  companies,  and 
the  making  of  investments.  In  the  United  States  this 
distinction  was  carried  still  farther,  and  as  our  tmst 
companies  grew  up  they  assumed  fiduciary  functions, 
acting  as  trustee,  receiver,  guardian,  and  in  many  other 
capacities.  They  were  often  essentially  investment 
institutions  deahng  in  long-term  securities,  bonds, 
mortgages,  and  the  hke.  Differentiated  from  these 
trust  companies,  were  the  savings  banks,  whose  duty 
it  was  to  gather  small  funds  from  a  great  number  of 
persons  and  to  invest  them  in  safe  securities  of  some 


TYPES  OF  BANKING   SYSTEMS     363 

kind  which  as  the  result  of  custom  came  to  be  chiefly 
real-estate  mortgages  in  various  forms.  The  commer- 
cial banks,  on  the  other  hand,  fell  into  one  or  two  broad 
classes  according  as  they  served  primarily  agricultural 
or  manufacturing  interests.  In  general  it  may  be  said 
that  the  progress  of  banking  development  tended, 
either  as  a  result  of  legislation  or  of  practice,  to  differ- 
entiation of  banldng  operations  either  on  the  basis  of 
security  taken,  or  of  period  for  which  loans  were  made, 
or  of  the  form  of  loan,  whether  in  the  form  of  an  actual 
advance  of  money  or  of  the  issue  of  notes,  or  the  estab- 
lishment of  deposit  accounts.  Looking  over  the  world 
to-day,  there  may  be  seen  in  the  less  developed  coun- 
tries many  banks  which  still  exercise  a  great  variety  of 
functions,  and  even  in  some  of  the  more  advanced 
commercial  countries,  as  in  the  United  States,  it  is  to 
be  observed  that  the  banks  in  the  more  primitive  com- 
munities perform  a  gi"eater  diversity  of  functions  than 
are  customarily  undertaken  by  the  larger  banks. 

VIII.  Specialized  Banking. 

The  question  has  naturally  presented  itself  in  most 
countries  whether  it  is  wise  to  attempt  by  law  to  develop 
banking  on  specified  lines,  recognizing  given  types  of 
institutions  and  enacting  codes  of  legislation  to  control 
them,  or  whether  it  is  better  to  allow  custom  and 
practice  to  differentiate  institutions  one  from  another. 
In  the  United  States  we  ha\e  sought  for  many  years 
past  to  legislate  in  such  a  way  as  to  define  and  to  develop 
different  types  of  institutions.  Thus  there  ha\-e  grown 
up  the  national  banking  system,  organized  under  the 
National  Bank  Act;  the  state  banking  systems, 
substantially  similar  to  the  national  system,  but  organ- 
ized under  state  acts,  which  vary  in  detail;  the  trust 
companies,  organized  under  state  law  and  differentiated 


364  BANKING  AND   BUSINESS 

sharply  from  banks;  the  savings  banks,  usually  estab- 
lished under  legislation  worked  out  in  utmost  detail; 
the  private  banking  houses  or  investment  houses,  some- 
times organized  under  general  law  or  otherwise  organ- 
ized under  legislation  specifically  intended  for  their 
governance;  and  a  variety  of  other  institutions  such 
as  rural  credit  associations,  mortgage  banks,  building- 
loan  associations,  and  the  Hke.  If  it  can  be  said  that 
there  has  been  an  underlying  theory  directing  this 
legislation,  that  theory  would  probably  be  held  to 
specify  that  there  should  be  limitation  of  functions, 
and  that  banking  operations  should  be  practiced  only 
along  narrow  lines  by  institutions  which  are  confined 
to  a  single  type  of  business.  This  theory  has  much  to 
sustain  it.  Credit  in  the  modern  world  assumes  an 
indefinitely  complex  form,  and  it  is  only  a  generaliza- 
tion from  experience  to  say  that  institutions  which 
assume  many  different  kinds  of  risks  are  not  usually 
able  to  judge  any  one  of  the  risks  very  accurately  or  to 
provide  carefully  against  it.  The  commercial  bank 
which  has  a  great  many  deposits  and  at  the  same  time 
is  lending  heavily  on  real  estate  or  long-term  securities 
is  always  in  danger  of  having  its  funds  so  ''tied  up"' 
that  it  cannot  free  a  sufficient  amount  of  them  for  the 
purpose  of  meeting  the  demands  of  customers  who  may 
call  for  the  redemption  of  deposits.  On  the  other  hand, 
the  institution  which  is  devoting  itself  chiefly  to  invest- 
ment and  fiduciary  operations  is  hardly  Hkely  to  be  in 
a  position  to  study  commercial  credit  carefully  unless 
it  organizes  a  specially  equipped  department  for  that 
purpose.  In  a  country  where,  as  in  the  United  States, 
the  idea  of  free  banking  has  been  tenaciously  adhered 
to,  it  was  almost  inevitable  that  there  should  be  an 
attempt  to  protect  the  pubhc  against  errors  on  the 
part  of  those  who  were  undertaking  the  banking  busi- 
ness, and  one  way  of  guaranteeing  such  protection  was 


TYPES  OF   BANKING   SYSTEMS     365 

to  limit  the  number  of  operations  in  which  men  of 
inexperience  or  poor  judgment  might  engage. 

In  some  foreign  countries  there  has  been  a  tendency 
to  work  along  the  same  line  partly  as  the  result  of  law, 
but  more  largely  as  the  outcome  of  custom,  and  lines 
of  distinction  have  been  drawn  almost  exactly  similar 
to  those  which  exist  in  the  United  States.  Neverthe- 
less, when  the  Federal  Reserve  Act  was  passed,  it  in- 
cluded a  provision  which  allowed  national  banks  to 
undertake  fiduciary  functions — that  is  to  say,  to  parallel 
and  compete  with  trust  companies,  and  this  bad  exam- 
ple in  legislation  has  been  followed  in  a  number  of 
states.  Acting  on  permission  thus  granted,  more  than 
1,000  national  banks  applied  for  and  received  permis- 
sion to  engage  in  trust-company  business.  Some  of 
them  have  taken  over  such  business  on  a  comparatively 
large  scale,  but  experience  is  already  demonstrating 
what  was  known  before — that  such  a  mixture  of  func- 
tions is  a  doubtful  venture.  When  successfully  under- 
taken it  involves  the  co-ordinate  organization  of  really 
separate  institutions  conducted  under  a  single  manage- 
ment, but  adhering  closely  to  the  dictates  of  conserva- 
tism and  experience  in  the  management  of  their  several 
kinds  of  business.  In  the  main,  it  may  fairly  be  said 
that  the  tendency  of  modern  nations  is  away  from  such 
combination  of  functions  and  is  toward  specialization. 

IX.  Organized  Banking. 

A  further  refinement  of  conditions  such  as  those 
which  have  been  sketched  in  the  case  of  institutions 
which  grow  up  with  their  functions  differentiated  as 
the  result  of  law  or  custom  is  found  in  those  countries 
where  a  definite  effort  has  been  made  to  relate  institu- 
tions to  one  another— that  is  to  say,  to  build  up  a 
definitely  organized  system  of  banking.     This  is  the 


366  BANKING  AND   BUSINESS 

third  of  the  "types"  of  banking  systems  already 
referred  to  on  page  361  of  this  chapter,  and  differs  from 
the  others,  as  there  suggested,  only  in  that  there  is  a 
very  much  more  clear-cut  notion  of  organization  or 
effort  to  establish  a  systematic  relationship  among  dif- 
ferent kinds  of  banks.  We  may  see  how  this  type  of 
banking  system  is  developed  by  casting  a  glance  at 
recent  American  history.  When  the  Federal  Reserve 
Act  was  first  under  consideration  the  intention  was  to 
confine  it  entirely  to  national  banks.  Political  pressure 
forced  the  admission  of  state  banks  and  trust  companies 
as  members  of  the  system,  so  that  there  was  thus  estab- 
lished a  distinct  classification  as  between  banks 
(national)  which  were  obliged  to  accept  membership 
and  those  which  were  only  voluntary  members.  When 
the  trust  companies  came  into  the  system  in  consider- 
able numbers  there  was  in  effect  a  third  gi'ouping  of 
membership,  national  and  state  banks  being  generally 
active  rediscounters,  while  many  trust  companies  came 
in  as  insm^ance  against  panic  or  for  the  sake  of  the 
prestige  and  advertising  which  they  derived  therefrom. 
In  the  Federal  Reserve  Act,  provision  was  made  for 
discounting  nonmember  bank  paper  under  specified 
conditions,  so  that  a  fourth  line  of  relationship  to  the 
inner  banking  organization  was  established — that  of 
nonmember  banks  permitted  to  obtain  accommodation 
indirectly  from  Federal  Reserve  banks  and  later  allowed 
also  to  use  the  collection  facihties  of  the  Federal  Reserve 
system. 

Further  organization  v,^as  provided  by  the  adoption 
of  the  Federal  Farm  Loan  Act,  whose  purpose  it  was 
to  furnish  agricultural  loans  to  the  farming  community 
and  which  gave  to  fann-loan  institutions  certain  rights 
in  the  use  of  the  facilities  of  the  Federal  Reserve  system 
for  the  holding  or  transferring  of  funds.  Under  the  old 
national  banking  system  and  in  some  of  the  state-bank 


TYPES  OF  BANKING   SYSTEMS     367 

systems,  provision  had  been  made  for  recognizing  dif- 
ferent groups  of  banks  as  central  reserve  city,  reser\'e 
city,  and  country  banks,  with  provisions  governing  the 
kind  of  deposits  permitted  to  be  made  by  one  with  the 
other.  Altogether,  therefore,  there  has  been  introduced 
in  the  United  States  a  very  substantially  de\'eIoped 
organization  in  which  the  discount  relationships  of 
banks  to  one  another  are  carefully  defined  and  in  which 
a  rather  strict  control  is  established  by  all  over  the 
types  of  business  that  may  be  undertaken  by  any 
of  them. 

Contrasting  this  situation  with  the  specialized  bank- 
ing system  of  England,  in  which  the  lines  of  distinction 
between  different  types  of  institution  are  even  more 
carefully  drawn  than  in  the  United  States,  but  in 
which  the  amount  of  law  relating  to  the  subject  is 
vastly  less  than  here,  the  distinction  drawn  between 
the  organized  type  of  banking  system  and  what  we 
have  called  the  specialized  type  is  obvious,  while  in 
both  cases  a  clear  line  of  distinction  exists  as  against 
the  heterogeneous  banking  system  in  which  institu- 
tions come  into  existence  with  the  privilege  of  doing 
practically  anything  that  they  choose.  It  remains 
true  that  in  many  parts  of  the  United  States,  and  in 
many  of  the  less  developed  countries  of  the  world,  the 
exercise  of  various  unrelated  functions  by  banks  is  still 
the  rule.  The  country  bank  in  the  western  part  of  the 
United  States  will  discount  local  commercial  paper, 
lend  on  long  term  to  farmers  with  mortgage  security, 
accept  savings  deposits  and  pay  interest  on  them,  dis- 
count the  notes  of  local  merchants,  furnish  domestic 
remittances,  make  collections,  hold  for  safekeeping  the 
valuables  of  customers,  and  perfonn  a  variety  of  other 
duties.  The  process  of  differentiation  goes  hand  in 
hand  with  the  progi'ess  of  the  community  in  the  division 
of  labor.     One  after  another  the  various  functions  of 


368  BANKING  AND   BUSINESS 

the  primitive  bank  are  sloughed  off  or  transferred  to 
other  institutions,  until  at  length  the  specialized  type 
of  banking  emerges  either  with  or  without  definite 
organization  of  the  kind  already  described. 

From  what  has  been  said  in  this  chapter  it  will  be 
seen  that  the  expression  "banking  system"  or  "type  of 
banking  system"  is  one  which  must  be  used  with 
caution  and  which  can  be  understood  only  in  connec- 
tion with  the  grade  of  industrial  situation  to  which  it 
applies;  while  still  more  caution  must  be  used  in  ap- 
proving or  disapproving  this  or  that  plan  of  organiza- 
tion until  there  is  exact  knowledge  as  to  the  conditions 
under  which  it  is  to  be  put  into  effect.  Banking  is  in 
one  aspect  a  branch  of  business  and  goes  hand  in  hand 
with  business.  It  cannot  be  developed  very  much 
faster  than  general  business  develops,  and  its  principles 
and  methods  must  always  be  those  which  render  it 
efficient  in  its  aid  to  and  support  of  general  business. 


CHAPTER  XXIII 

BANKING   ABROAD 

Works  on  banking  frequently  include  a  somewhat 
detailed  description  of  European  central  banking  in- 
stitutions, such  as  the  banks  of  England,  France, 
Germany,  etc.,  and  the  discussion  is  sometimes  at  least 
presented  in  such  a  way  as  to  suggest  the  thought  that 
these  "central  banking  countries"  are  fully  provided 
for  each  by  its  own  central  bank  which  entirely  meets 
the  needs  of  the  population.  In  fact,  central  banking 
has  been  usually  the  outcome  of  a  slow  evolution. 

In  most  European  countries  the  development  of 
banking  has  been  a  long  process  extending  o\'er  some 
hundreds  of  years.  There  has  been  a  fairly  well- 
marked  tendency  toward  the  development  of  a  single 
type  of  banking  organization,  but  there  are  still  \'ery 
broad  differences  of  method  and  even  of  theory 
between  European  banking  systems.  A  review  of  the 
history  of  the  European  countries  shows  that  in  prac- 
tically all  of  them  banking  began  as  a  more  or  less 
unregulated  private  occupation,  and  that  as  the  busi- 
ness grew  to  greater  importance  it  gradually  fell 
under  the  supervision  of  the  government,  to  some 
extent  at  least,  or  was  subjected  to  control  by  a 
central  institution  in  which  the  government  took  a 
strong  part  and  which  became  sufficiently  active  in 
the  market  to  exert  a  powerful  influence  over  banking 
transactions  in  general. 

Most  of  the  non-European  countries  which  were  or- 


370  BANKING  AND   BUSINESS 

ganized  on  the  modern  industrial  basis  by  immigration 
from  Em'ope  have  naturally  followed  European  models 
in  banking  organization.  Nevertheless,  a  very  con- 
siderable difference  of  practice  and  method  had  devel- 
oped in  many  of  them,  owing  to  differences  in  local 
needs,  prior  to  the  European  War.  It  should  be  em- 
phasized, moreover,  that  the  student  of  foreign  banking 
will  do  well  to  differentiate  sharply  between  the  condi- 
tions relating  to  banking  and  currency  which  existed 
prior  to  the  European  War  and  those  which  have  de- 
veloped subsequent  to  the  close  of  the  struggle.  At  the 
present  time  monetary  conditions  practically  the  world 
over  are  abnormal,  and  scientific  analysis  of  banking 
systems,  especially  those  of  Europe,  must  confine  itself 
very  largely  to  prewar  conditions,  although  taking  ac- 
count, as  a  matter  of  information,  of  the  transitory 
problems  which  have  arisen  of  recent  years. 

Looking  back  for  the  moment  entirely  to  prewar 
conditions  and  confining  attention  exclusively  to 
western  Europe,  it  may  be  said  that  the  standard  form 
of  banking  organization  which  had  grown  up  during  the 
commercial  development  of  the  nineteenth  century  was 
essentially  a  co-ordinated  or  centralized  system  in 
which  a  fairly  sharp  line  of  diidsion  had  been  drawn 
between  banking  functions  that  could  to  best  advantage 
be  carried  on  as  a  private  or  individual  matter  and  other 
functions  which  were  better  performed  as  a  matter  of 
community  action  or  joint  and  common  responsibility. 
As  representative  of  the  former  may  be  taken  the  task 
of  making  direct  loans  or  extending  credit  to  individuals, 
while  as  representative  of  the  latter  may  be  cited  the 
issuing  of  notes.  In  practically  every  European  coun- 
try the  duty  of  issuing  notes  had  been  taken  over  almost 
entirely  by  a  central  banking  institution,  while  in  one 
way  or  another  this  institution  had  also  acquired  the 
responsibility  for  holding  the  bulk  of  the  reserve  funds  of 


BANKING  ABROAD  371 

the  community.  In  like  manner  the  central  bank  had 
usually  been  assigned  the  duty  of  holding,  recei\'ing, 
and  disbursing  the  public  funds  of  the  nation. 

On  the  other  hand,  in  practically  every  country  it 
had  been  found  undesirable  to  have  the  central  bank, 
acting  as  it  did  on  behalf  of  the  financial  community 
as  a  whole  and  vested  as  it  was  with  a  pubhc  quahty, 
discharge  the  duty  of  testing  private  credit  or  of  carry- 
ing the  responsibility  for  loans  to  individuals,  or  that 
of  regulating  or  controUing  relations  with  foreign 
countries  by  furnishing  exchange.  It  may  be  stated 
generally,  therefore,  that  European  countries  had 
fairly  closely  concentrated  the  functions  of  note  issue, 
of  the  handhng  of  pubhc  funds,  and  of  the  conservation 
of  reserves,  and  had  tended  to  decentraUze  the  other 
functions  of  banking. 

Particularly  was  such  decentralization  deemed  to  be 
desirable  in  the  case  of  loans  to  specific  classes  of  enter- 
prise w^hich  were  vested  with  a  pecuhar  character  of 
their  own.  In  nearly  all  of  the  European  countries 
there  had  accordingly  been  developed  classes  of  institu- 
tions known  as  export  banks,  whose  function  it  was  to 
facilitate  foreign  trade,  land-credit  institutions  of 
various  kinds  intended  to  assist  agriculture,  and  spe- 
cialty banking  establishments  which  devoted  them- 
selves to  meeting  the  recjuirements  of  certain  elements 
in  the  financial  and  business  community. 

A  brief  sketch  of  some  of  the  principal  foreign  banks, 
intended  to  present  certain  of  their  salient  features,  will 
now  be  necessary.  Effort  is  made  only  to  furnish  the 
basic  facts  concerning  each  of  the  systems,  both  as 
originally  developed  and  as  modified  by  war  conditions. 
It  should  be  remembered,  of  course,  that  the  exist- 
ing situation  in  practically  all  foreign  countries  is 
purely  one  of  transition,  the  war  having  brought  about 
changes  which  cannot  be  considered  permanent. 


372  BANKING  AND   BUSINESS 

I.  The  Bank  of  England. 

The  oldest  among  banking  systems  in  anything  Uke 
their  present  form  is  the  Bank  of  England,  which  dates 
from  1694,  and  which  as  operated  to-day  finds  its  funda- 
mental charter  in  the  Bank  Act  of  1844,  which  super- 
seded earlier  statutes.  The  bank,  although  owned  by 
individual  stockholders,  is  to  all  intents  and  purposes 
a  public  institution  whose  most  important  functions 
are  the  general  direction  and  control  of  the  money 
market,  the  handling  of  government  finances,  and  the 
supplying  of  a  uniform  note  circulation. 

Cheat  Britain  was  the  earliest  country  to  develop 
banking  upon  the  modern  highly  specialized  and  dif- 
ferentiated basis.  At  the  close  of  the  seventeenth 
century  England  had  already  advanced  far  toward  a 
recognition  of  the  special  functions  perforaied  by  the 
issue  of  bank  notes  and  of  the  necessity  of  centralizing 
a  certain  proportion  of  the  banking  resources  of  the 
country  in  the  hands  of  one  institution.  At  that  time 
there  was  in  existence  a  considerable  number  of  bank- 
ing houses  operating  in  competition  with  one  another 
and  controlled  by  no  single  policy;  owing,  moreover, 
no  obligations  to  the  government  save  those  owed  by 
any  good  citizen. 

IJnder  the  Act  of  1844  the  issue  department  of  the 
bank  was  permitted  to  put  out  notes  only  when  pro- 
tected pound  for  pound  by  coin  or  bullion,  except  that 
a  basic  issue  of  £14,000,000  sterling  might  be  placed  in 
circulation  upon  a  basis  of  the  government  debt. 
Other  banks  of  issue  were  to  transfer  their  note-issue 
privilege  from  time  to  time  to  the  Bank  of  England, 
and  such  transfers  were  to  bring  about  an  increase 
in  the  issues  of  the  Bank  of  England  to  the  extent  of 
two-thirds  of  the  independent  bank  circulation  so 
retired.     Before  the  war  the  note  issue  secured  by 


BANKING   ABROAD  373 

government  bonds  had  thus  risen  to  the  equivalent  of 
about  SOO, 000,000,  the  total  outstandings  being  about 
S150,000,000. 

The  function  of  the  Bank  of  England  in  controlling 
the  market  is  exerted  by  the  performance  of  a  very  con- 
servative commercial  banking  business  based  upon  the 
discounting  of  short-tenn  paper,  partly  for  banks  and 
partly  for  individuals,  the  bank,  where  necessary,  going 
out  into  the  open  market  and  buying  such  paper  of 
specified  amounts  as  might  be  available.  Before  the 
European  War  the  handling  of  govermnent  finances 
consisted  largely  of  the  receiving  of  public  funds  and 
the  disbursing  of  them  upon  suitable  check  or  warrant, 
or  from  time  to  time  conversion  operations  in  the  long- 
tenn  debt  when  necessary,  accompanied  occasionally 
b}^  short-term  advances.  The  war  changed  England's 
financial  structure  to  a  great  extent,  bringing  about 
alterations  which  may  or  may  not  be  pemianent.  In 
the  Currency  and  Bank  Notes  Act  of  1914,  converti- 
})ility  of  currency  and  bank  notes  into  gold  was  pro- 
\'ided  for,  but  for  several  reasons  has  never  been  really 
effective.  The  goverimient  had  issued,  early  in  the 
war,  treasury  notes  which  \'aried  in  amount  from  time 
to  time,  and  at  the  tune  of  the  annistice  probably 
amounted  to  about  £1,600,000,000.  Under  the  Cur- 
rency and  Bank  Notes  Act  both  currency  notes  and 
Bank  of  England  notes  were  made  legal  tender  for  any 
amount,  and  both  kinds  of  cuiTency  have  continued  to 
circulate  in  large  volume,  the  total  in  currency  notes 
outstanding  at  the  close  of  1921  being  £423,000,000. 
It  may  be  assumed  that  eventually  the  currency  notes 
will  be  retired  and  the  Bank  of  England  may  succeed 
in  getting  back  to  a  basis  of  actual  convertibility  of 
notes  into  gold. 

The  war,  however,  has  made  but  little  change  in  the 
actual  practice  of  banking  in  Great  Britain.     For  a  long 


374  BANKING  AND   BUSINESS 

time  it  has  been  the  custom  of  other  banks  to  carry 
their  reserves  in  the  form  of  deposits  with  the  Bank  of 
England.  la  the  United  Kingdom  as  a  whole  there  are 
to-day  about  seventy-five  institutions,  and  while  the 
Scotch  and  Irish  banks  are  in  a  sense  more  or  less 
independent  of  the  Bank  of  England,  they  do  in  prac- 
tice carry  considerable  balances  with  the  latter,  while 
the  so-called  Enghsh  joint-stock  banks,  with  head- 
quarters in  London,  have  been  in  the  habit  of  carrying 
the  bulk  of  their  reserves  with  the  head  office  of  the 
bank.  While  the  Bank  of  England  has  at  the  present 
time  eleven  branches  here  and  there,  these  are 
merely  for  the  purpose  of  convenience,  the  English 
joint-stock  banks  having  much  more  numerous  branches 
which  serve  as  the  actual  medium  of  communication 
with  the  public  at  large.  The  Bank  of  England  has  of 
recent  years,  although  carrying  a  certain  number  of 
deposit  accounts  for  private  individuals  and  also  doing  a 
discount  business  for  such  customers,  tended  to  become 
more  and  more  a  bankers'  bank,  dealing  largely  in 
bankers'  acceptances  and  confining  its  operations  so 
far  as  practicable  to  liquid  paper.  During  the  war, 
like  all  other  banking  institutions,  the  Bank  of  England 
was,  however,  obliged  to  make  very  large  advances  to 
the  government  on  the  strength  of  the  treasury  notes 
or  short-term  bonds  issued  by  the  latter.  Such  issues 
were  not  a  satisfactory  basis  for  the  creation  of  deposit 
credit  or  the  issue  of  currency,  and  the  level  of  prices, 
partly  as  a  result  of  this  method  of  banking,  accord- 
ingly advanced  about  100  per  cent  between  1913  and 
a  date  soon  after  the  armistice.  Effort  was  made  by 
British  financiers  of  the  more  conservative  group  to 
obtain  a  cessation  of  government  short-term  borrowing 
from  the  Bank  of  England,  but  without  any  material 
success,  although  the  total  volume  of  such  loans  has  in 
the  aggregate  fallen  off.    There  has  been  a  steadily 


BANKING   ABROAD  375 

declining  movement  of  government  obligations  toward 
the  banks  and  a  steady  increase  in  the  amount  of 
government  obligations  absorbed  and  held  by  indi\'id- 
uals.  One  of  the  important  features  of  postwar  de- 
velopment in  Great  Britain  has  been  the  tendency  of 
the  larger  banks  to  consolidate,  there  being  at  the 
present  time  five  outstanding  institutions  of  great  size. 
Both  in  the  case  of  the  Bank  of  England  and  in  that 
of  other  European  banks,  it  seems  that  a  restoration  of 
convertibility  of  paper  and  deposits  into  gold  can  be 
effected  only  in  case  the  foreign  balance  of  the  coun- 
try's trade  is  restored  to  a  suitable  level,  and  such  a 
result  can  be  accomplished  only  through  increased 
exportation  and  reduced  importation,  associated  prob- 
ably with  the  borrowing  of  considerable  amounts  in 
actual  gold  from  foreign  countries.  It  is  as  yet  uncer- 
tain how  or  under  what  conditions  so  extensive  a  reform 
as  is  indicated  can  be  brought  about. 

II.  The  Bank  of  France. 

Dating  from  1803,  the  Bank  of  France  is  in  many 
important  respects  analogous  to  the  Bank  of  England 
in  its  organization  and  general  public  service.  The 
public  service  of  the  bank,  however,  is  in  France  rela- 
tively less  important  as  compared  with  its  service  to 
the  individual  than  in  England.  On  the  other  hand, 
the  method  by  which  the  Bank  of  France  extends 
credit  is  quite  different  from  that  adopted  by  the  Bank 
of  England,  ^yhereas  in  Great  Britain,  as  ah-eady 
noted,  the  principal  means  of  lending  to  the  individual 
is  the  bank  deposit,  so  that  the  bulk  of  all  transac- 
tions are  effected  by  checks,  in  France  the  bulk  of  the 
business  is  transacted  through  payments  made  in  notes, 
so  that  the  advances  of  the  Bank  of  France  are  naturally 
in  large  measure  in  the  note  form.    Its  statement,  there- 


376  BANKING  AND  BUSINESS 

fore,  shows  a  very  large  volume  of  notes  in  circulation 
and  a  relatively  small  volume  of  deposits,  whereas  in 
England  before  the  war  the  total  of  notes  outstanding 
was  relatively  small,  while  the  volume  of  deposits  was 
disproportionately  large.  The  Bank  of  France  has 
about  six  hundred  branches  scattered  through  the 
various  "departments,"  or  districts,  into  which  France 
is  divided,  and  direct  discounting  is  carried  on  to  a 
very  considerable  extent  with  the  pubHc  at  large.  The 
paper  discounted  is  small  in  amount  and  has  at  times 
run  down  to  very  low  figures.  The  bank  has  been  in  the 
habit  of  requiring  such  paper,  when  purchased  or  dis- 
counted by  it,  to  be  indorsed  by  a  banker,  which  in 
effect  has  made  its  transactions  practically  rest  upon 
the  footing  of  bankers'  acceptances,  or  the  equivalent 
thereof,  so  that  the  French  market  received  the  support 
of  the  Bank  of  France  through  this  requirement  of 
insurance  of  credit  risks,  even  though  it  was  true  that 
the  bank  was  deahng  largely  with  the  actual  customers 
who  made  the  paper  as  the  result  of  business  transac- 
tions. Partly  owing  to  the  very  broad  powers  of  the 
Bank  of  France  and  the  habit  of  deahng  with  the  pub- 
lic very  widely,  however,  the  development  of  the 
French  credit  and  banking  system  has  been  on  a  much 
more  limited  scale  than  in  England,  relatively  few 
banks  having  developed  there.  There  existed  in  France 
before  the  war  a  certain  number  of  deposit  banks 
whose  total  deposits  were  less  than  about  $12,000,000, 
and  twelve  credit  institutions  with  deposits  amounting 
to  $5,084,000,000.  These  institutions  had  many 
branches  scattered  throughout  the  country  and  dealt 
largely  in  investment  securities.  Such  banks,  Hke  the 
British  joint-stock  banks,  rediscounted  directly  with 
the  Bank  of  France,  which  in  turn  issued  to  them 
notes,  and  these  notes  were  held  by  them  in  their 
vaults  as  a  basis  for  their  own  operations.    As  in  the 


BANKING   ABROAD  377 

case  of  the  Bank  of  England,  the  Bank  of  France 
possessed  a  very  decided  pubhc  function  and  was  called 
upon  not  only  to  receive  and  disburse  government 
funds,  but  under  the  terms  of  its  charter  might  be 
required  to  loan  up  to  200,000,000  francs  (about  S40,- 
000,000)  to  the  state.  Although  the  stock  of  the  Bank 
of  France  was  privately  owned,  the  go\'ernment  had 
power  to  appoint  its  higher  officers  and  practically  to 
control  it  in  essential  particulars.  During  the  war  the 
Bank  of  France  underwent  much  the  same  changes  of 
function  and  structure  as  did  other  central  banks, 
except  that,  owing  to  the  great  strain  placed  upon  the 
institution,  these  changes  were  probably  more  far- 
reaching  and  severe  than  elsewhere.  A  great  inflation 
took  place  as  the  result  of  direct  discounting  of  go\'ern- 
ment  paper  and  the  issue  of  notes  against  it  and  the 
rapid  development  of  an  adverse  trade  balance.  Both 
currency  and  credit  inflation  became  the  rule  under 
the  French  system,  and  while  bank  deposits  up  to  the 
time  of  the  armistice  had  grown  only  about  70  per  cent, 
circulation  of  Bank  of  France  notes  had  increased  to 
about  37,000,000,000  francs  as  against  some  6,000,- 
000,000  before  the  war.  Withdrawal  of  gold,  refusal 
to  allow  its  exportation,  widespread  use  of  bank-not-e 
currency,  and  \'arious  other  expedients  for  controlling 
exchange  and  money  values  were  put  into  effect  during 
the  war.  Practically  all  of  them  tended  to  render  the 
banking  situation  more  difHcult  and  to  depreciate  the 
value  of  the  notes  and  deposits  of  the  Bank  of  France 
as  stated  in  terms  of  foreign  currency.  Although  this 
depreciation  was  for  a  time  held  in  check  through  the 
adoption  of  a  j^lan  of  stabilizing  exchange,  such  sta- 
bilization was  never  very  successful  and  was  eventually 
discontinued  a  few  months  after  the  armistice.  The 
value  of  the  inflated  notes  and  credits  was  thus  left  to 
take  care  of  itself  and  has  since  been  far  below  nominal 


378  BANKING  AND   BUSINESS 

parity,  the  franc,  which  was  worth  19.3  cents  in  Ameri- 
can money  before  the  war,  being  quoted  at  the  close  of 
1921  at  about  1}/^  cents  in  American  money. 

III.  The  Reichsbank. 

Banking  had  developed  in  Germany  along  very  much 
the  same  lines  as  in  England  and  France  during  the 
period  from  1875  onward.  Germany,  broken  as  it  was 
into  a  considerable  number  of  independent  states  prior 
to  the  war  of  1870-71,  had  not  developed  any  general 
system  of  banking,  but  in  most  of  the  German  states 
there  had  grown  up  state  banks  more  or  less  remotely 
resembling  the  Bank  of  England  or  the  Bank  of  France, 
and  as  a  rule  charged  with  the  handling  of  government 
finances  and  the  furnishing  of  note  currency  under  a 
monopolistic  charter.  After  the  formation  of  the  Ger- 
man Empire  it  was  desired  to  create  a  more  unifonn 
discount  market  and  system  of  banking,  and  accord- 
ingly the  Reichsbank  was  established  under  the  Act 
of  1875,  which  substituted  the  new  institution  for  the 
older  Bank  of  Prussia,  which  dated  from  1765.  The 
Reichsbank  was,  in  general  thought,  modeled  upon 
the  lines  of  the  Bank  of  England,  but  in  many  impor- 
tant particulars  it  sought  to  introduce  methods  which 
were  better  adapted  to  German  conditions.  With  a 
capital  of  180,000,000  marks,  its  note  issue  was  allowed 
to  run  up  to  250,000,000  marks,  a  sum  which  was  later 
increased  to  slightly  less  than  550,000,000  miarks.  The 
older  banks  in  the  several  German  states  retained  their 
right  of  issuing  currency,  but  it  was  pro\'ided,  just  as  in 
England,  that  if  they  failed  to  exercise  them  or  gave 
them  up  at  any  time,  allowing  them  to  lapse  into 
disuse,  they  should  be  transferred  automatically  to  the 
Reichsbank.  Government  relationship  with  the  manage- 
ment of  the  bank  was  modeled  upon  the  system  which 


BANKING   ABROAD  379 

had  been  developed  in  France.  The  chancellor  of  the 
Empire  was  made  president  of  the  bank,  four  other 
members  of  the  council  of  control  being  also  appointed 
by  the  government.  Representation  of  private  stock- 
holders was  furnished  by  a  special  board,  which  was 
placed  in  charge  of  the  routine  business.  The  charter 
of  the  Bank  of  Germany  evidently  contemplated  that 
the  bulk  of  the  business  of  the  institution  would  be 
conducted  on  the  basis  of  credits  established  through 
the  issue  of  notes,  as  in  France  and  other  continental 
countries,  hence  an  exceptionally  careful  effort  to  limit 
the  issues,  it  being  pro\'ided  that  under  ordinary  cir- 
cumstances the  fixed  amount  of  notes  specified  in  the 
law  should  not  be  exceeded,  although  under  exceptional 
conditions  notes  might  be  issued  by  them  to  this 
limit  upon  condition  that  the  bank  pay  a  tax  of  five- 
forty-eighths  of  one  per  cent  per  week,  or  about  5 
per  cent  per  annum,  upon  all  such  excess  circulation. 
All  of  the  circulation,  moreover,  was  to  be  pro- 
tected by  a  holding  of  bills  running  not  over  three 
months  and  secured  by  two  signatures.  In  its  general 
business  the  Reichsbank  was  intended  to  be  a  bankers' 
bank,  doing  businevSS  primarily  with  other  institutions 
and  hmiting  itself  for  the  most  part  to  very  short- 
term  paper.  Loans  were  made  both  on  commercial 
paper  and  on  the  basis  of  approved  securities.  Sur- 
rounding the  Bank  of  Germany  there  have  developed 
about  twent}'  large  joint-stock  institutions,  each  with 
a  system  of  agencies  and  branches.  Taking  Germany 
as  a  whole,  the  total  number  of  banks  is  estimated  at 
from  three  to  four  thousand,  most  of  them  very  small 
local  institutions.  The  German  banks  quite  con- 
sciously were  developing  along  the  same  lines  as  were 
being  followed  by  the  English  institutions  prior  to  the 
war.  Conditions,  however,  were  materially  altered  by 
the  war  along  lines  that  must  be  briefly  sketched. 


380  BANKING  AND   BUSINESS 

Germany,  in  the  expectation  that  the  war  would  be 
short,  had  not  arranged  to  revise  her  system  of  taxation, 
but  undertook  to  provide  the  necessary  means  through 
banking  advances  and  currency  issues.  Later,  long- 
term  loans  were  resorted  to.  Provision  was  made  soon 
after  the  opening  of  the  war  for  giving  the  notes  of 
the  Reichsbank  legal-tender  power,  while  government 
treasury  notes  were  also  issued.  The  bank  was  allowed 
to  hold  these  treasury  notes  and  treasury  obhgations  as 
protection  for  its  own  notes,  and  a  special  kind  of  bank 
organized  for  war  purposes  made  large  advances  to 
borrowers  against  government  bonds.  The  effect  was 
to  increase  the  quantity  of  circulating  medium  in 
Germany,  including  both  coin  and  notes,  from  about 
5,500,000,000  marks  before  the  war  to  about  41,000,- 
000,000  marks  at  the  middle  of  1919.  During  the  post- 
armistice  financing  period  there  was  a  large  addition 
to  the  floating  debt,  and  the  notes  of  the  Reichsbank 
were  enormously  expanded,  so  that  by  the  end  of  1921 
the  outstanding  circulation  was  over  100,000,000,000 
marks,  and  the  mark  was  quoted  in  New  York  as  low 
as  three  tenths  of  a  cent.  While  there  was  no  material 
change  in  the  status  of  the  outside  banks,  they  tended, 
as  in  England,  to  become  more  and  more  concentrated 
and  fewer  in  number,  small  and  weak  banks  being 
absorbed.  This  process  was  considerably  accelerated 
by  the  bad  foreign-exchange  situation  of  Germany. 

IV.  Canadian  System. 

The  Canadian  banking  system  differs  materially  from 
the  standard  central  banking  systems  of  Europe,  being 
without  any  central  banking  organization  and  consist- 
ing of  seventeen  large  specially  chartered  banks  dating 
from  various  periods,  all  authorized  to  issue  nqtes  in 
established  branches  and  several  of  them  maintaining 


BANKING  ABROAD  381 

large  networks  of  branches  throughout  Canada.  The 
note  issue  of  Canadian  banks  is  Umited  to  an  amount 
equal  to  the  capital  of  each  issuing  institution,  and  a 
joint  guaranty  fund  is  established  through  a  fund 
deposited  with  the  Canadian  government  and  kept 
constantly  on  deposit  for  the  purpose  of  redeeming 
the  notes  of  any  bank  that  may  fail.  In  the  event 
of  a  bank  failing,  its  notes  become  a  lien  upon  the 
assets  of  the  bank  and  may  be  redeemed  out  of  the 
guaranty  fund.  The  notes  also  draw  interest  from  the 
time  of  the  suspension  of  the  bank  issuing  them.  Of 
late  years  the  extension  of  credit  by  means  of  deposit 
accounts  on  books  of  the  Canadian  banks  has  increased, 
but  the  notes  continue  to  be  the  characteristic  form  of 
bank  credit  over  a  large  part  of  Canada.  During  the 
war  the  Dominion  government  issued  govenmient  cir- 
culating notes  secured  by  bonds  deposited  by  the  banks 
under  approved  conditions,  while  gold  redemption  was 
suspended  both  as  to  bank  notes  and  as  to  Dominion 
notes  (government  legal-tender  notes).  Dominion 
notes  were  not  issued,  however,  in  very  large  amount 
at  any  time,  and  the  main  effort  of  Canada  was  to  con- 
serve her  supply  of  gold  and,  as  in  the  United  States, 
to  further  the  raising  of  war  loans  by  providing  for 
their  discount  on  liberal  terms  at  banking  institutions. 
Apart  from  the  method  of  note  issue,  the  most  striking 
phase  of  Canadian  banking,  as  well  as  the  one  to  which 
reference  is  most  frequently  made  in  the  descri])tion 
of  banking  systems,  is  the  extensive  creation  of  l^ranch 
banks.  This  has  gone  so  far  that,  notwithstanding 
only  seventeen  banks  exist  in  Canada,  they  with  their 
branches  constitute  a  number  of  banking  offices  open 
to  the  public  which  is  fully  as  large  in  proportion  to  the 
population  as  is  provided  by  the  independent  banking 
system  of  the  United  States.  The  l^ranch  banking 
system  has  had  two  great  merits,  that  of  easily  shift- 


382  BANKING  AND   BUSINESS 

ing  funds  from  one  part  of  the  country  to  another 
as  wanted,  and  the  other  that  of  equahzing  rates 
of  discount  as  between  different  parts  of  the  country. 
Both  factors  have  proved  exceedingly  beneficial  and 
helpful  in  the  course  of  Canada's  economic  and  financial 
growth. 

V.  Other  European  Banking  Systems. 

Most  of  the  banking  systems  of  the  world  have  been 
developed  in  comparatively  recent  times  and  have  been 
modeled  more  or  less  closely  upon  the  practices  of 
France,  England  and  her  colonies,  or  Germany.  In 
those  cases,  as  in  Italy,  where  much  older  banks  existed, 
the  organization  and  methods  of  such  banks  have  been 
adapted  from  time  to  time  along  hnes  which  had 
been  worked  out  in  the  more  highly  developed  modem 
countries  where  banking  principles  had  been  most 
fully  appUed.  Among  the  countries  which  before  the 
war  were  regarded  as  having  fairly  well-estabhshed 
banking  systems  were  Italy,  Spain,  the  Scandinavian 
countries,  and  Russia — Russia's  banking  sj^stem  being 
far  less  highly  developed  and  much  more  prunitive  in 
its  methods  than  those  of  other  countries.  Switzer- 
land had  developed  a  national  bank  entitled  the 
Federal  State  Bank,  as  well  as  a  series  of  cantonal 
banks,  outside  of  which  were  the  privately  organized 
institutions  of  various  kinds  and  which  had  succeeded 
in  developing  a  money  market  there  similar  to  that 
existing  in  France. 

VI.  Banking  in  South  America. 

South  American  countries  had  had  a  banking  expe- 
rience widely  different  in  character  from  that  of  Em-ope 
prior  to  the  outbreak  of  war  in  1914.    None  of  them 


BANKING   ABROAD  383 

was  an  active  participant  in  the  struggle  and  hence 
none  was  subject  to  such  serious  distortion  of  its  bank- 
ing system  as  was  true  of  European  countries,  although 
changes  and  disturbances  have  none  the  less  been 
significant. 

A  representative  South  American  country,  in  so  far 
as  banking  and  credit  are  concerned,  is  Argentina.  Her 
banking  system  had  before  the  war  been  developed 
very  largely  after  the  English  plan,  its  central  support 
being  the  Banco  de  la  Nacion,  a  central  government 
bank.  Associated  with  this  institution  was  a  national 
land-credit  bank  whose  function  it  was  to  lend  on  land 
mortgages  and  issue  bonds  to  investors,  out  of  whose 
proceeds  the  mortgage  loans  were  pro\'ided  for.  For- 
eign banking  has  always  had  an  important  status  in 
Argentina,  British,  French,  and  German  institutions 
organizing  branches  which  did  an  active  commercial 
business.  American  banks,  after  the  organization  of 
the  Federal  Reserve  system,  likewise  established 
branches  in  Argentina,  so  that  the  crecUt  needs  of  the 
population  in  export  and  import  trade  were  largely 
supplied  through  the  efforts  of  outside  institutions. 
Domestic  banking  needs  were  met  by  the  national 
bank  and  its  branches.  At  the  close  of  the  war  the 
national  bank  was  in  possession  of  about  SSG.OOO.OOO 
in  gold  and  about  S300,000,000  in  paper,  the  amount  of 
government  notes  and  deposit  accounts  being  about 
$777,000,000.  Gold  and  gold  ol)ligations,  amounting 
to  about  S484,000,000,  were  held  by  the  government. 
No  serious  alterations  of  the  prewar  system  occurred 
as  the  result  of  monetary  disturbances,  but  transfers 
continued  to  be  made  on  the  basis  of  actual  payment, 
although  the  export  of  gold  was  forbidden,  save  under 
special  license,  with  a  view  to  protracting  the  monetary 
supply.  An  advance  in  prices  that  took  place  in  s\th- 
pathy  with  prices  in  other  countries  did  not,  on  the 


381  BANKING  AND   BUSINESS 

whole,  bring  the  banking  and  currency  position  into 
jeopardy. 

In  Chile,  a  system  somewhat  similar  to  that  prevail- 
ing in  Argentina,  and  on  the  whole  modeled  upon 
British  lines,  has  been  in  process  of  development  for 
many  years  past.  The  Banco  de  Chile,  with  a  capital 
of  $120,000,000  subscribed,  of  which  $60,000,000  has 
been  paid  up,  has  been  the  central  factor  in  the  finan- 
cial organization  of  the  country,  issuing  notes  and 
creating  deposits.  S-^veral  other  local  institutions, 
organized  with  native  capital,  have  done  a  good  busi- 
ness, their  relations  to  the  Banco  de  Chile  being  some- 
what similar  to  those  between  the  British  joint-stock 
banks  and  the  Bank  of  England.  Several  foreign  bank- 
ing houses  have  also  operated  in  Chile,  as  they  have 
in  Argentina,  and  to  them  has  been  committed  in  large 
measure  the  financing  of  the  exports  and  imports  of 
the  country.  An  issue  of  government  notes  has  been 
in  circulation  for  more  than  thirty  years,  the  amount 
of  the  issue  gradually  increasing  up  to  $150,000,000  in 
1914.  Special  issues  of  notes  were  provided  for  at  the 
outbreak  of  the  war  in  order  to  facihtate  the  develop- 
ment of  the  nitrate  industry,  but  there  has  not  been, 
either  before  or  since  the  war,  any  issue  of  genuine 
bank  notes,  the  sole  circulating  currency  being  the 
government  issues  already  referred  to.  Immediately 
after  the  war  the  gold  holdings  of  the  Chilean  banks 
were  probably  in  the  neighborhood  of  $103,000,000,  or 
about  the  same  as  at  the  opening  of  the  contest. 

In  other  South  American  countries  systems  of  bank- 
ing are  in  large  measure  similar  to  those  of  the  two 
countries  already  described,  except  that  in  some  the  par- 
ticipation of  foreign  banks  has  been  much  greater  than 
in  the  more  stable  and  powerful  South  .\merican  states. 
^ATiere  foreign  capital  has  succeeded  in  acquiring  a  foot- 
hold it  has  occasionally  come  to  exercise  a  practicallj'" 


BANKING   iVBROAD  385 

dominating  influence  in  the  local  financial  institutions, 
oftentimes  through  the  control  of  the  central  bank  even 
when  such  bank  possessed  a  monopoly  of  note  issue. 

VII.  Banking  in  the  Far  East. 

Banking  in  the  Far  East  varies  greatly  from  country 
to  country,  some  nations  and  states  ha^'ing  reached  a 
substantiall}^  high  degree  of  de\'elopment  following 
Western  models,  while  others  are  far  behind  in  the 
degree  of  their  growth.  Probably  the  most  complete 
and  well-developed  banking  system  in  the  Far  East 
is  that  of  Japan.  There  a  banking  system  patterned 
upon  European  models  has  been  established  with  the 
Bank  of  Japan,  a  note-issuing  institution,  acting  prac- 
tically as  a  bankers'  bank  and  as  a  stat-e  bank  somewhat 
similar  to  the  plan  that  prevails  in  England.  Japan's 
coinage  system  before  the  war  was  monometallic,  anil 
the  Bank  of  Japan's  notes  were  and  are  convertible 
into  gold.  Public  funds  are  kept  in  the  Bank  of  Japan, 
and  deposits  and  withdrawals  made  after  ortlinary 
banking  methods.  The  principal  change  necessitated 
by  the  war  was  the  issue  of  currency  notes  by  the 
Japanese  Treasury,  but  the  convertibility  of  the  notes 
of  the  Bank  of  Japan  has  be^'U  steadily  maintained. 
Several  strong  and  well-organized  commercial  banks 
have  been  created  by  special  charter  in  Japan,  these 
including  the  Yokohama  Specie  Bank,  the  Bank  of 
Taiwan,  the  Industrial  Bank  of  Japan,  and  various 
others,  while  ordinary  banking  institutions  may  be 
incorporated  under  general  legislation  which  regulates 
their  operation.  Foreign  banks  have  always  main- 
tained an  important  position  in  Japan  through  the 
establishment  of  branches  which  finance  export  and 
import  trade,  but  their  relati\e  control  over  the  inter- 
nal business  of  the  country  has  of  late  years  decUned. 


386  BANKING  AND  BUSINESS 

In  China,  a  highly  complex  and  very  unstable  bank- 
ing and  currency  system  exists,  domestic  banks  being 
established  in  the  various  provinces,  with  practically 
little  or  no  control  over  them  on  the  part  of  the  gov- 
ernment. The  Bank  of  China,  which  was  estabhshed 
a  few  years  ago  and  was  authorized  to  issue  notes,  has 
only  a  limited  lending  power  and  has  never  reached 
any  very  significant  degree  of  development.  Many  for- 
eign banks  have  established  branches  at  so-called  treaty 
ports  on  the  coast  of  China,  and  their  operations  are 
directed  largely  to  financing  importation  and  exporta- 
tion. These  banks  have  been  established  from  time  to 
time  as  branches  of  home  institutions  operated  in  vari- 
ous countries  and  their  business  has  been  subject  to 
very  little  oversight  or  control.  Few  of  them  have 
issued  regular  statements,  and  practically  all  have  been 
allowed  in  certain  circumstances  to  circulate  notes 
which  have  attained  a  more  or  less  broad  field  of  use, 
according  to  the  scope  of  the  trade  conducted  by  the 
merchants  belonging  to  the  country  under  whose  laws 
a  given  bank  was  incorporated. 

In  British  India,  while  there  have  been  many  native 
banks,  the  principal  functions  of  foreign-trade  financing 
and  of  ordinary  banking  business  in  the  commercial 
sense  have  been  conducted  by  British  institutions 
either  with  their  home  offices  in  London  or  in  some  of 
the  various  Indian  cities.  This  has  prevented  the 
development  on  a  large  or  well-organized  scale  of  a 
definite  Indian  banking  system,  although  the  ordinary 
needs  of  the  population  in  general  have  been  met  by 
the  establishment  of  native  institutions  with  branches 
throughout  the  country. 

In  Australia,  for  many  years  the  banking  facilities 
were  provided  in  much  the  same  way  as  in  Canada, 
through  local  incorporation  of  note-issuing  banks  or 
through  the  establishment  of  branches  by  British  insti- 


BANKING   ABROAD  387 

tutions  with  head  offices  in  London.  As  a  result  of 
the  organization  of  banks  by  these  methods  some 
twenty-five  main  institutions  were  estabhshed  in  Aus- 
traha  and  several  of  them  developed  large  networks  of 
branches  extending  throughout  the  several  Australian 
states.  In  1912  the  Commonwealth  Bank  was  brought 
into  existence  as  a  government-owned  institution  whose 
function  was  chiefly  to  handle  the  funds  of  the  central 
government.  This  Commonwealth  Bank  has  tended 
at  times  to  develop  into  more  or  less  of  a  bankers'  bank, 
somewhat  after  the  plan  of  the  Bank  of  England,  but 
has  never  yet  succeeded  in  establishing  itself  fully  in 
that  capacity,  so  that  there  has  always  been  more  or 
less  competition  between  it  and  the  other  local  institu- 
tions. While  the  Commonwealth  Bank  issues  notes 
which  have  many  of  the  attributes  of  the  government 
currency,  the  other  Australian  banks  are  likewise 
authorized  to  issue  notes  under  the  laws  of  the  several 
states,  and  do  so,  the  result  being  to  estabhsh  a  very 
large  circulation  of  bank  notes.  Such  bank  notes, 
however,  are  maintained  convertible  into  Connnon- 
wealth  notes  at  the  various  offices  of  the  issuing  banks. 

VIII.  Conclusions. 

The  hasty  survey  which  has  thus  been  made  of  for- 
eign systems  of  banking  leads  to  the  conclusion  that 
while  there  has  been  no  absolutely  unifonn  trend  of 
development  in  foreign  countries,  the  general  move- 
ment has  been  toward  the  creation  of  central  banks, 
usually  exercising  the  function  of  not«-issuing  and  oper- 
ating more  or  less  as  bankers'  banks.  In  most  countries 
such  banks  are  surrounded  by  a  corps  of  other  institu- 
tions, which  in  some  cases  may  be  allowed  to  issue 
notes,  but  have  ordinarily  tended  to  become  deposit 
banks,  either  confining  themselves  to  local  loans  or  else 


388  BANKING  AND   BUSINESS 

engaging  in  foreign-exchange  operations  as  well.  There 
is  a  distinct  division  between  the  countries  of  the  world 
as  to  the  scope  and  extent  of  branch  banking.  The 
tendency  in  Great  Britain,  the  British  colonies,  and  in 
various  other  parts  of  the  world  has  been  toward  the 
establishment  of  large  networks  of  branches,  with  a 
corresponding  concentration  of  banking  power  in  the 
home  offices  of  the  various  institutions  which  maintain 
such  systems.  In  other  parts  of  the  world  branch  bank- 
ing has  made  less  progress,  and  there  has  been  a  con- 
siderable tendency  toward  individualization  of  banking. 
This  would  seem  to  be  true  in  a  number  of  South 
American  states  and  also  in  some  parts  of  the  Far  East. 
Among  the  western  European  countries,  France  and 
Italy  have  seemed  inclined  to  move  in  the  direction  of 
individualization  of  banking,  or,  at  all  events,  have  not 
adopted  the  branch  system  in  the  same  highly  developed 
degree  as  has  been  true  of  other  countries. 

Details  of  banking  organization  differ  quite  mate- 
rially from  country  to  country,  but  the  tendency  has 
been  to  give  to  the  government  either  a  stockholding 
interest  or  else  a  very  distinct  power  of  control  or  of 
operation  in  the  central  reserve  institution  of  each 
country,  while  other  banks  have  for  the  most  part 
been  left  in  the  hands  of  individuals,  the  government's 
control  over  them  being  expressed  either  through  gen- 
eral banking  laws  designed  to  prescribe  operations  which 
may  or  may  not  be  embarked  upon,  or  in  part  through 
more  or  less  frequent  examination  and  inspection  of 
accounts.  The  United  States  stands  out  separately 
from  the  rest  of  the  world  in  having  prohibited  the 
branch  system  within  the  country,  and  consequently 
as  having  sought  the  development  of  a  highly  individ- 
ualized system  of  banking  units,  which,  however,  are 
now  united,  through  the  stock  o^\Tiership  of  the  twelve 
Federal  Reserve  banks,  into  a  co-operative  system. 


CHAPTER  XXIV 1 

EVOLUTION  OF  THE  AMERICAN   BANKING  SYSTEM 

While  there  is  not  much  use  in  studying  banking 
from  the  standpoint  of  ancient  history,  or  in  an  anti- 
quarian way,  it  is  of  considerable  importance  to  under- 
stand how  existing  banking  institutions  have  developed 
and  what  is  the  practice  in  regard  to  banking  in  other 
countries  of  the  world.  It  is  by  such  study  that  the 
existing  banking  problem  is  properly  apprehended  and 
that  the  foundation  is  laid  for  a  suitable  understanding 
of  what  should  be  done  in  the  way  of  legislation  for  the 
improvement  of  present  methods. 

The  nineteenth  century  is  a  period  exceedingly  rich 
in  banking  experience.  During  that  century  a  great 
variety  of  banking  methods  were  tried,  and  theory  after 
theory  was  taken  up,  appHed,  and  discarded.  So  also 
in  the  matter  of  practice  a  great  transformation  was 
brought  about  and  banking  methods  were  almost  revo- 
lutionized. This  makes  the  banking  history  of  the 
nineteenth  century  of  very  great  value  to  the  student 
of  the  subject  from  the  practical  standpoint. 

In  the  United  States,  a  review  of  banking  history 
will  show  that  many  of  the  numerous  schemes  and  pro- 
posals now  brought  forward  from  time  to  tune  as 
original  have  been  tried,  worked  out,  and  thrown  aside. 
Here  and  there  a  good  plan  or  system  has  been  dis- 
carded for  inadequate  reasons,  and  an  outhne  of  past 

'Material  for  this  chapter  has  been  largely  drawn  by  permission 
of  the  publishers  (L:i  Salle  Extension  University,  Chicago,  Illinois)  from 
the  1916  edition  of  American  Banking,  by  H.  P.  WilUs. 


390  BANKING  AND   BUSINESS 

efforts  shows  why  the  changes  then  introduced  were 
unwise  and  why  a  return  to  some  methods  then  aban- 
doned may  be  beneficial. 

I.  First  and  Second  Banks  of  the  United  States. 

When  the  government  of  the  United  States  was  first 
organized  it  found  that  banking  institutions  were 
ahnost  entirely  lacking  in  this  country.  Owing  to  the 
bad  condition  of  the  currency  and  the  disorganization 
of  commercial  credit,  there  was  a  strong  desire  that  the 
government  should  participate  actively  in  restoring 
business  to  a  condition  of  greater  soundness,  and  par- 
ticularly that  it  should  aid  in  establishing  a  banking 
system  upon  a  working  basis.  At  that  time  the 
dominant  banking  idea  in  European  countries  was 
that  of  large  chartered  banks  standing  close  to  the 
government.  There  was  such  an  institution  in  Eng- 
land, and  Alexander  Hamilton,  who  was  the  conspicu- 
ous figure  in  our  government  so  far  as  concerned  all 
matters  of  finance,  recommended  the  estabUshment  of 
a  strong  institution  of  like  kind  to  handle  the  finances 
of  the  government,  issue  bank  notes,  and  generally  act 
as  a  conservative  and  unifying  influence  in  the  financial 
system  of  the  country.  Such  a  bank  w^as  chartered 
and  went  into  operation  in  1791.  This  was  the  First 
Bank  of  the  United  States.  A  twenty-year  charter 
was  granted  to  it.  This  charter  followed  very  much 
the  same  lines  that  had  been  recommended  by  Hamil- 
ton in  his  famous  report.  The  details,  of  course,  were 
shaped  in  Congress  to  suit  the  necessities  of  the  situa- 
tion, but  the  main  ideas  are  clearly  recognizable. 

The  bank  was  given  a  capital  of  $10,000,000  divided 
into  25,000  shares  of  $400  each.  Of  this  sum  $8,000,000 
was  open  to  subscription  by  the  pubHc,  while  the  other 
$2,000,000  was  to  be  subscribed  by  the  United  States 


AMERICAN   BANKING   SYSTEM      391 

and  paid  in  ten  equal  annual  installments,  with  interest 
at  G  per  cent.  The  subscriptions  to  the  stock  were  to 
be  paid  one-fourth  in  specie  and  three-fourths  in  gov- 
ernment 6-per-cent  bonds.  Each  shareholder  was 
entitled  to  cast  one  vote  for  one  share,  one  vote  for  the 
next  two  shares,  etc.,  up  to  thirty  votes,  which  was 
practically  the  maximum  vote  that  could  be  cast  by 
any  one  man.  The  power  to  inspect  all  the  affairs 
of  the  bank  except  the  accounts  of  private  individuals 
was  given  to  the  head  of  the  Treasury,  and  he  was  also 
authorized  to  call  for  reports  as  often  as  once  a  week 
if  he  chose.  The  notes  were  made  receivable  for  public 
dues  as  long  as  they  continued  to  be  payable  in  gold 
and  silver.  The  bank  was  allowed  to  establish  branches 
wherever  the  directors  thought  fit,  but  only  for  dis- 
count and  deposit.  No  trade  of  any  kind  could  be 
engaged  in,  and  the  bank  was  not  allowed  to  hold  real 
estate,  though  it  might  lend  on  mortgage  security, 
while  it  was  not  permitted  to  become  indebted  for  an 
amount  greater  than  its  deposits.  This  practically 
limited  the  issues  of  notes  to  an  amount  not  in  excess 
of  the  capital  stock.  The  bank  was  to  transact  the 
fiscal  business  of  the  government,  and  in  return  it  was 
given  an  exclusive  charter  for  twenty  years. 

The  capital  of  the  bank  was  almost  instantly  sub- 
scribed, and  the  institution  promptly  went  into  opera- 
tion. It  proved  to  be  a  great  success,  rendering  the 
currency  of  the  country  much  more  stable,  supjilying 
the  needed  banking  accommodation,  and  pro\iding  a 
note  currency  which  was  on  the  whole  quite  satisfactory. 
It  was  very  successful  in  controlling  the  state  institu- 
tions and  assuring  prompt  j)aymeut  of  their  obligations, 
especially  of  the  circulating  notes  issued  by  them.  In 
transacting  the  government's  business,  making  loans 
as  desired,  etc.,  it  met  the  necessities  of  the  situation 
very  satisfactorily. 

26 


392  BANKING  AND   BUSINESS 

There  was,  nevertheless,  a  considerable  opposition 
to  the  bank  from  the  first,  and  this  grew  stronger  as 
the  time  came  for  the  expiration  of  the  charter.  1  he 
bank  stockholders  were  of  course  desirous  of  continu- 
ing, and  as  early  as  1808  they  petitioned  for  a  renewal. 
Their  apphcation  was  supported  by  Secretary  of  the 
Treasury  Gallatin,  who  showed  that  the  go\^ernment 
had  made  a  handsome  profit  on  its  stock,  besides  earn- 
ing dividends  averaging  8  3-8  per  cent  per  aimum. 
The  bank  was  in  an  exceedingly  strong  position  at  this 
time,  as  it  had  on  hand  about  $5,000,000  in  specie, 
while  its  loans  and  discounts  were  $15,000,000,  and 
consisted  chiefly  of  short-term  paper.  The  opposition 
was  due  to  the  fact  that  a  large  proportion  of  the 
shares  was  owned  abroad,  and  that  the  profits,  there- 
fore, went  to  foreign  stockholders,  while  the  antagonism 
of  the  state  banks,  which  had  been  growing  in  number, 
was  very  strong.  After  a  bitter  struggle.  Congress 
declined  to  renew  the  charter,  and  the  bank  went  out 
of  existence  at  the  expiration  of  the  original  charter  in 
1811. 

It  was  an  unfortunate  tune  at  which  to  make  a  change 
in  the  system  of  banking.  The  War  of  1812  was  on 
the  point  of  breaking  out,  and  the  government  had 
reached  a  stage  where  it  more  than  ever  needed  the  aid 
of  a  strong  financial  institution.  The  removal  of  the 
First  Bank  of  the  United  States  took  away  the  check 
that  had  been  imposed  upon  the  small  state  banks, 
and  the  result  was  that  their  issues  were  largely  in- 
flated during  the  years  immediately  follo'W'ing  the  cessa- 
tion of  the  bank's  operations.  Added  to  this  was  the 
fact  that  the  government  speedily  fell  into  a  condition 
of  disordered  finance  and  was  obliged  to  borrow  from 
the  state  banks  and  then  to  sell  bonds  wherever  it 
could,  finally  resorting  to  issues  of  so-called  "treasury 
notes,"  which  were  reaUy  small  United  States  bonds 


AMERICAN   BANKING   SYSTEM      393 

that  ultimately  degenerated  into  a  kind  of  cur- 
rency. Finally  conditions  became  so  bad  that  pro- 
posals were  put  forward  for  the  organization  of  a  new 
bank  of  the  United  States ;  and  after  the  failure  of  sev- 
eral proposals  of  this  sort  Congress  succeeded  in  passing 
a  new  charter  in  1816. 

The  Second  Bank  of  the  United  States  was  modeled 
very  closely  upon  the  plan  which  had  worked  so  suc- 
cessfully in  the  case  of  the  First  Bank.  The  capital 
was  $35,000,000,  one-fifth  to  be  subscribed  by  the 
government,  while  one-fourth  of  the  public  subscrip- 
tions was  required  to  be  in  coin  and  three-fourths 
either  in  coin  or  government  securities.  In  order  to  be 
assured  of  an  exclusive  charter  for  twenty  years,  the 
bank  was  to  pay  the  government  a  bonus  of  SI, 500, 000. 
PubUc  deposits  were  to  be  made  in  the  Bank  of  the 
United  States  unless  the  Secretary  of  the  Treasury 
should  order  otherwise,  laying  his  reasons  for  such 
order  before  Congress  at  its  next  session.  In  the 
event  of  failure  to  pay  notes  or  deposits  on  demand 
in  specie,  the  bank  was  to  be  obliged  to  pay  12  per 
cent  annually  on  the  amount  of  its  obligations  thus 
refused. 

There  was  no  trouble  in  selling  the  shares,  but  when 
they  had  been  sold  the  subscriptions  came  in  slowly. 
The  original  charter  had  provided  that  individuals 
should  pay  their  subscriptions  30  per  cent  when  sub- 
scribing, 35  per  cent  in  six  months,  and  35  per  cent  in 
twehe  months,  ^^^len  the  time  came  for  the  pajTiient 
of  the  second  installment  the  specie  came  in  only  to  a 
small  extent,  and  when  the  third  installment  fell  due 
\'ei'y  few  of  those  who  owed  it  met  their  obhgations  on 
time.  The  bank  discounted  the  not«s  of  stockholders 
to  a  large  amount,  and  made  loans  on  its  own  shares 
to  a  substantial  oxtont. 

The  effect  of  aU  this  vsas  to  thi-ow  the  institution 


394  BANKING  AND   BUSINESS 

practically  into  a  condition  of  insolvency,  and  it  re- 
quired strenuous  effort  to  get  back  to  a  working  basis. 
Such  a  basis  was,  however,  established  by  1819,  and, 
through  an  arrangement  with  the  leading  state  banks, 
resumption  of  specie  payments  (which  had  been  sus- 
pended during  the  War  of  1812)  was  accomplished. 
From  the  time  that  the  bank  was  placed  in  safe  hands, 
however,  it  began  to  apply  a  rigid  system  of  control 
to  the  state  institutions  and  insisted  on  their  keeping 
their  notes  redeemed  in  coin  upon  presentation. 
Branches  were  established  here  and  there  as  needed, 
and  the  note  currency  issued  by  it  became  a  practically 
universal  circulating  medium.  Although  the  bank 
carried  on  various  operations  that  were  probably  out- 
side the  scope  of  its  charter  and  did  not  conform 
altogether  closely  to  the  limitations  with  respect  to 
methods  of  issuing  circulating  notes,  it  was  undoubtedly 
the  most  powerful  and  best-managed  financial  institu- 
tion the  country  had  seen,  and  its  effect  was  to  supply 
a  far  greater  soundness  and  a  far  higher  degree  of  con- 
venience and  efficiency  in  making  payments  than  had 
ever  before  been  experienced. 

The  Second  Bank,  however,  like  its  predecessor,  fell 
into  difficulties  because  of  political  opposition.  There 
was,  as  usual,  the  antagonism  of  the  state  banks,  which 
were  restive  under  the  restraining  authority  of  the 
overshadowing  federal  institution  and  desired  to  see  it 
done  away  with  that  they  might  get  more  business  and 
be  freer  tX)  do  as  they  chose.  Besides  this  there  were 
large  general  influences  of  a  political  character  militat- 
ing against  the  bank,  and  the  persistent  opposition  of 
President  Jackson  focused  all  this  antagonism  in  an 
irresistible  w'ay.  A  recharter  was  consequently  re*, 
fused,  just  as  in  the  case  of  the  First  Bank. 

The  bank  then,  in  1836,  obtained  a  charter  for  thirty 
years  from  the  state  of  Pennsylvania,  thus  becoming  a 


AMERICAN  BANKING  SYSTEM      395 

state  institution  and  retaining  its  original  §35,000,000 
of  capital.  Up  to  this  point  the  bank  had  occupied  a 
thoroughly  sound  position,  but  it  now  found  itself 
with  too  large  a  capitalization  for  the  more  restricted 
field  in  which  it  was  compelled  to  operate.  The  result 
was  that  loans  of  doubtful  character  were  undertaken, 
and  finally  the  bank  was  obliged  to  suspend  and  go  into 
liquidation  in  1841. 

The  experience  of  the  First  and  Second  United  States 
banks  is  of  great  interest  at  the  present  time  on  account 
of  the  tendency  toward  centralized  banking  control.  It 
should  be  noted,  of  course,  that  both  the  First  and 
Second  United  States  banks  were  institutions  decidedly 
of  a  different  type  from  any  that  exist  or  would  be 
likely  to  exist  at  the  present  day.  Thus,  in  1834,  when 
the  Second  Bank  of  the  United  States  was  in  an  exceed- 
ingly flourishing  condition,  its  loans  were  $55,000,000, 
deposits  about  $11,000,000,  circulation  about  $19,000,- 
000,  and  specie  about  $10,000,000.  It  thus  had  approx- 
imately one-third  of  its  circulation  and  deposits  in  the 
form  of  specie,  while  circulation  was  well  toward  double 
the  amount  of  the  deposits.  This  is  undoubtedly  a 
different  condition  from  that  which  would  be  exhibited 
by  any  such  bank  at  the  present  time.  Its  methods  of 
doing  business  were  also  radically  different  from  those 
that  would  be  followed  to-day.  The  lessons  that  can 
be  obtained  from  the  history  of  the  First  and  Second 
banks  do  not  lie  along  the  line  of  routine  banking 
business,  but  are  rather  to  be  found  in  connection  \\'ith 
the  type  of  government  control  and  the  relation  between 
the  central  banks  and  the  local  banks. 

It  is  plain  that  political  questions  will  always  be  of 
considerable  importance  in  connection  with  any  gov- 
ernment bank,  and,  as  in  the  case  of  the  First  and 
Second  banks,  they  proved  destructive,  so  they  might 
wreck  any  governmentally  controlled   central   bank. 


396  BANKING  AND   BUSINESS 

Whether  these  questions  would  be  rendered  easier  of 
solution  by  allowing  the  small  local  banks  to  own  the 
stock  of  the  national  bank,  and  thereby  eliminate  their 
jealousy  in  a  measure  as  well  as  some  portion  of  the 
political  controversy  connected  with  such  an  institu- 
tion, is  a  doubtful  point. 

The  experience  of  these  central  banks  showed  that 
very  excellent  results  could  be  obtained  by  giving  to 
such  an  institution  the  management  of  public  funds  and 
intrusting  it  with  the  duty  of  making  transfers  and 
carrying  on  those  portions  of  the  fiscal  duties  of  the 
government  that  are  distinctly  of  a  banking  type. 
Experience  with  both  these  banks  also  showed  the  good 
results  that  can  be  obtained  through  the  issue  of  a 
uniform  bank-note  currency,  elastic  in  character,  but 
amply  secured  by  sound,  short-time  commercial  paper 
accepted  in  the  course  of  an  exceedingly  conservative 
loan  and  discount  business. 

II.  Development  of  State  Banking. 

While  the  Second  Bank  of  the  United  States  had  been 
running  its  course,  the  various  states  had  been  experi- 
menting with  different  kinds  of  banking  systems,  some 
successfully  and  others  disastrously.  In  the  course  of 
this  experience  alnaost  every  type  of  banking  was 
attempted,  and  the  result  was  the  accumulation  of  a 
great  fund  of  experience  as  to  the  best  way  in  which 
not  to  conduct  banking.  Among  the  distinct  tj^pes  of 
banking  systems  developed  during  the  first  half  century 
of  our  national  life  were  the  so-called  New  England 
system,  the  bond-secured  system  of  New  York,  the 
"state  banks"  (banks  owned  and  operated  by  state 
governments  or,  at  all  events,  very  closely  controlled 
by  them),  and  the  so-called  "credit  systems"  of  bank- 
ing.    Of  all  these  systems  the  one  that  stands  out 


AMERICAN   BANKING   SYSTEM      397 

as   having   been    conspicuously    successful    was    that 
established  in  New  England. 

1.  New  England  System. 

The  New  England  banks  had  been  chartered  by  the 
several  states  in  which  they  exist-ed,  but  very  shortly 
came  to  feel  a  much  higher  degree  of  community  of 
interest  and  to  recognize  a  much  stronger  necessity 
for  co-operati\'e  action  than  did  the  banks  of  any  other 
section.  This  led  to  the  development  of  a  certain 
degree  of  uniformity  in  the  banking  laws  of  the  New 
England  states.  As  a  result,  there  was  a  large  territory 
through  which  a  sound  and  safe  state  bank  currency 
existed  and  which  formed  a  striking  contrast  to  the 
conflicting  and  largely  unsound  systems  found  in  other 
portions  of  the  United  States. 

The  main  outlines  of  this  so-called  "New  England 
system"  were  as  follows:  Banks  were  allowed  to  issue 
notes  as  they  pleased,  without  any  special  security 
behind  the  note  other  than  the  general  assets  of  the 
institution.  As  a  rule,  however,  thej'^  were  forbidden 
to  issue  an  amount  of  notes  greater  than  100  or  125 
per  cent  of  the  amount  of  their  capital.  The  capital 
itself  had  to  be  actually  paid  up  ^\'ithin  a  reasonable 
length  of  time,  and  in  some  states  the  stockholders  were 
required  to  be  liable  in  case  of  loss  to  an  amount  equal 
to  the  amount  of  the  capital,  or  in  some  cases  to  a 
greater  amount.  In  Massachusetts  the  banks  were  not 
allowed  to  incur  liabilities  beyond  a  specified  amount, 
and  there  was  a  more  or  less  careful  inspection  and 
examination  of  accounts  by  state  officials.  The  de- 
nominations of  the  bank  notes  were  quite  generally 
regulated  so  as  to  prevent  the  issuing  of  too  many  small 
notes.  In  this  way  a  fairly  satisfactory  degree  of  state 
control  was  secured,  and  the  business  of  banking  was 
placed  upon  a  very  substantial  basis.     So  sound  was  the 


398  BANKING  AND   BUSINESS 

situation  that  the  New  England  banks  were  able  to 
maintain  specie  pajnnents  in  1814,  when  the  other  banks 
of  the  country  suspended.  They  got  into  trouble  in 
the  panic  of  1837,  but  were  much  less  affected  than 
were  the  banks  elsewhere,  returning  to  specie  pay- 
ments and  sound  methods  considerably  earher. 

One  great  element  in  the  success  of  the  New  England 
banks  was  found  in  a  plan  which  was  not  required  of 
the  banks  by  any  law,  but  was  the  result  of  voluntary 
co-operation  on  their  part.  This  was  the  so-called 
"Suffolk  system  of  redemption."  The  banks  had 
found  it  hard  to  maintain  constant  and  steady  redemp- 
tion of  notes,  and  observed  that  the  sounder  institutions 
suffered  from  the  practices  of  those  that  were  \\ining 
to  go  as  far  as  they  could  in  evading  prompt  redemption 
and  in  resorting  to  more  or  less  questionable  methods. 
The  result  was  a  desire  to  enforce  prompt  redemption 
of  notes,  and  this  was  accomplished  by  the  so-called 
''Suffolk  system." 

Under  this  system,  the  New  England  banks  joined 
in  establishing  a  redemption  office  in  Boston,  which 
was  carried  on  by  the  Suffolk  Bank.  This  bank  was 
incorporated  in  Boston  in  1818,  and  a  substantial  num- 
ber of  the  New  England  banks  joined  in  a  plan  whereby 
they  made  a  permanent  deposit  of  $2,000  each  with  the 
Suffolk  Bank,  and  in  addition  such  sum  as  was  needed 
for  the  current  redemption  of  notes.  At  first  the 
country  banks  were  unwilling  to  join  the  system, 
because  they  found  that  their  notes  gained  a  wider 
circulation  when  they  w^ere  at  a  slight  discount,  since 
in  the  latter  case  they  displaced  the  notes  of  the  Boston 
banks,  which  were  naturally  held  by  the  people  who 
received  them  and  who  presented  for  redemption  the 
depreciated  country  notes,  these  being  paid  out  in  the 
course  of  ordinary-  business. 

The  essential  work  of  the  Suffolk  Bank,  therefore, 


AMERICAN   BANKING   SYSTExM      399 

was  to  retire  all  the  country  notes  it  could  get  hold  of 
and  then  send  them  home  promptly  for  redemption. 
Wlien  the  system  had  got  fairly  started,  it  was  strong 
enough  to  retire  the  notes  of  large  numbers  of  banks 
and  thus  compel  immediate  redemption,  thereby  greatly 
hmiting  the  circulation  of  the  banks  that  put  these 
notes  out.  The  country  banks  were  finally  obliged  to 
yield  and  to  make  the  required  deposit  with  the  Suf- 
folk Bank,  which  thereafter  redeemed  their  notes  at 
par  when  presented,  charged  them  up  to  the  banks 
that  had  issued  them,  and  sent  them  home  whenever 
desired. 

This  system  was  tantamount  to  the  establishment 
of  a  clearing  house  for  note  issues  and  practically  offset 
the  notes  of  one  bank  against  those  of  another  in  mak- 
ing settlements.  Consequently  it  was  not  long  before 
the  circulation  of  all  the  banks  became  much  less 
redundant  than  it  had  been.  Occasionally  a  bank,  irri- 
tated by  the  hmitation  upon  its  circulation,  withdrew 
from  the  system,  but  in  such  cases  it  usually  found 
that  its  notes  fell  into  discredit  and  were  received 
only  in  the  inmiediate  locality  where  it  was  situated. 
The  Suffolk  Bank  system  thus  furnished  a  striking 
object  lesson  of  the  good  effects  of  prompt  redemption 
of  bank  notes,  and  this  was  exceedingly  influential  in 
later  banking  legislation. 

2.  New  York  System. 

Early  banking  in  New  York  was  conducted  on  the 
same  general  plan  as  in  the  first  banks  of  New  England 
— that  is,  without  any  specific  security  behind  the 
notes.  Charters  were  granted  on  a  somewhat  political 
basis  by  the  legislature  during  the  early  years  of  the 
state,  but  a  considerable  number  of  defects  appeared, 
just  as  was  the  case  in  New  England  })rior  to  the 
development  of  more  uniform  legislation  there  and  the 


400  BANKING  AND   BUSINESS 

institution  of  the  Suffolk  system  of  redemption.  As 
about  thirty  bank  charters  were  to  expire  between 
1829  and  1833,  it  was  considered  a  favorable  oppor- 
tunity for  introducing  a  change.  The  result  was  the 
adoption  of  what  was  called  the  ''safety-fund  plan," 
the  banks  being  rechartered  under  this  system.  By 
the  plan  proposed,  each  bank  had  to  pay  to  the  Treas- 
urer of  the  state  an  amount  equivalent  to  one-half  of 
one  per  cent  of  its  capital  stock  until  it  had  paid  in 
3  per  cent  of  its  capital.  This  then  was  treated  as  a 
joint  fund  to  make  good  the  liabihties  of  any  insolvent 
bank  if  its  assets  were  inadequate. 

The  fund  proved  to  be  insufficient  during  the  dif- 
ficult years  after  1837,  and,  consequently,  in  1842,  the 
money  was  made  appUcable  simply  to  the  notes  of  in- 
solvent banks,  the  other  liabihties  being  left  to  be  paid 
out  of  the  assets.  This  brought  the  liabilities  that 
might  become  a  charge  against  the  safety  fund  more 
nearly  within  the  control  of  the  fund  itself.  There 
had  been  some  opposition  to  the  safety-fund  plan;  and, 
as  a  result  of  a  campaign  for  ''free  banking,"  the  New 
York  Legislature  passed  the  "Free  Banking  Act"  on 
April  18,  1838. 

Under  this  Act  any  group  of  individuals  might 
establish  a  bank  and  issue  notes,  but  they  could  get  the 
notes  only  from  the  state  Comptroller  after  depositing 
with  him  bonds  of  the  United  States  or  the  state  of 
New  York  or  of  any  other  state  approved  by  the 
Comptroller,  while,  under  certain  circumstances,  they 
could  also  issue  notes  secured  by  bonds  and  mortgages 
upon  improved  productive  real  estate.  There  was  a 
considerable  development  of  banking  under  this  law, 
but  the  note  issues  had  very  little  elasticity,  and  were 
not  as  satisfactory  as  those  of  the  safety-fund  banks. 
The  system  was  gradually  perfected,  however,  imtil  the 


AMERICAN   BANKING   SYSTEM      401 

notes  protected  by  special  deposits  of  securities  were 
very  safe. 

S.  " State  Banks." 

The  success  of  the  First  and  Second  United  States 
banks  naturally  led  to  the  growth  of  unitations,  and  in 
a  number  of  states  banks  modeled  upon  the  federal 
institutions  were  established.  Thus  the  states  of  South 
Carolina,  Ohio,  Indiana,  and  some  others  created  insti- 
tutions some  of  which  proved  decidedly  successful. 

Perhaps  the  best  example  of  banks  of  this  kind  was 
the  institution  established  by  the  state  of  Indiana 
in  1834.  This  bank  had  a  capital  of  $1,600,000,  one- 
half  owned  by  the  state  and  the  other  half  by  private 
individuals,  though  the  state  was  in  full  control.  One 
parent  institution  at  Indianapolis  and  ten  branches, 
each  with  a  capital  of  $160,000,  made  up  the  organiza- 
tion. The  parent  bank  did  no  business,  but  consisted 
merely  of  a  president  and  board  of  directors  who  con- 
trolled the  operations  of  the  branches  which  thus 
constituted  a  system  of  banks.  The  management  of  the 
bank  was  throughout  careful  and  scientific,  and  the 
profits  were  very  handsome.  The  bank  made  its  loans 
largely  through  the  issue  of  notes  and  these  notes  were 
redeemed  in  specie  upon  presentation.  The  hostihty 
of  politicians  led  to  the  discontinuance  of  the  bank,  and 
a  free  banking  system  was  established. 

Other  state  banks  worked  along  very  much  the  same 
lines,  and  wherever  the  management  was  honest  and 
careful  and  the  capital  was  bona  fide,  the  result  was 
successful.  In  various  cases,  however,  banks  were 
established  without  adequate  capital,  their  chief  assets 
consisting  of  state  securities  which  were  of  doubtful  value 
and  their  specie  being  limited  in  amoimt.  In  other 
states  imitations  of  the  New  York  free  banking  system, 
with  requirements  based  on  the  compulsory  deposit  of 


402  BANKING   AND   BUSINESS 

bonds  or  mortgages  with  the  state  authorities,  were 
not  infrequent,  and  of  course  did  not  produce  notes 
of  greater  soundness  than  the  securities  on  which  they 
were  based.  Thus  a  great  many  unsound  banks  issuing 
"bond-secured  notes"  came  into  existence.  They 
were  no  worse  and  no  better  than  the  banks  that  were 
established  after  the  New  England  plan,  issuing  notes 
based  on  the  general  assets  of  the  institutions,  but  un- 
protected by  any  special  deposit. 

Out  of  all  these  conflicting  systems  there  developed 
a  gradual  tendency  toward  better  banking  conditions 
and  wise  management.  After  the  discontinuance  of  the 
Second  Bank  of  the  United  States  there  ensued  a  severe 
panic,  starting  in  1837,  and  due  in  part  to  unwise  bank- 
ing and  the  undue  extension  of  credit  upon  improper 
or  inadequate  security.  The  result  was  to  enforce  the 
banking  lessons  that  had  already  been  afforded  and  to 
warn  the  banks  against  repetition  of  the  practices  which 
had  led  to  inflation  and  disaster.  There  was  a  gradual 
improvement  in  methods  between  1840  and  1860. 
But  the  evils  of  a  decentralized,  widely  diffused,  and 
uncontrolled  system  of  banking  continued  to  exist. 

At  the  opening  of  the  Civil  War  there  were  more  than 
1,600  kinds  of  bank  notes  in  circulation.  Counter- 
feits were  numerous  and,  except  for  voluntary  arrange- 
ments made  by  groups  of  banks  among  themselves, 
there  was  nothing  to  compel  any  bank  to  receive  the 
notes  of  any  other  bank.  Redemption  facilities  were 
crude  and  poor  throughout  most  of  the  country,  and 
there  was  a  strong  feeling  in  favor  of  some  change  in 
the  direction  of  more  powerful  central  control  that 
would  guarantee  a  more  uniform  note  issue.  The  need 
of  such  control  was  emphasized  by  further  banking 
difficulties  in  1857,  which,  although  by  no  means  so 
severe  as  those  of  preceding  periods  of  panic,  were, 
nevertheless,  disturbing. 


AMERICAN   BANKING   SYSTEM      403 

III.  Independent  Treasury  System. 

Meanwhile  the  government,  discouraged  and  an- 
annoyed  at  the  experience  it  had  had  after  the  discon- 
tinuance of  the  Second  Bank  of  the  United  States,  had 
estabUshed  the  so-called  ''independent  treasury  sys- 
tem." Prior  to  this  an  effort  had  been  made  to  fall 
back  once  more  upon  the  state  banks,  the  deposits  of 
the  government  formerly  kept  with  the  Bank  of  the 
United  States  being  apportioned  or  distributed  among  a 
number  of  banks.  The  panic  of  1837  and  the  resulting 
suspension  embarrassed  the  government  and  enforced 
the  necessity  of  getting  some  plan  that  would  retain 
the  funds  under  real  and  genuine  control  of  the  federal 
administration.  After  various  expedients  had  been 
suggested  and  their  adoption  had  been  unsuccessfully 
sought,  Congress  created  the  independent  treasury 
system  which  assumed  substantially  its  present  form 
in  1846. 

The  idea  of  this  system  was  that  the  go"\^ernment 
should  entirely  dissociate  itself  from  the  state  banks 
and  should  pay  only  coin  and  receive  only  coin.  When- 
ever it  had  a  surplus  of  money  on  hand,  such  funds 
were  to  be  kept  in  specie  in  vaults  provided  for  that 
purpose.  It  was  reasoned  that  this  would  keep  the 
government  entirely  independent  of  the  banks  and  their 
vicissitudes.  The  system  was  put  into  operation  and 
was  carried  on  with  fair  success  down  to  the  opening 
of  the  Civil  War.  During  that  time  expenses  and 
incomes  were  not  far  from  being  in  a  condition  of 
equilibrium,  and  the  system  worked  with  comparative 
smoothness. 

It  was  evident,  h()we\'er,  even  at  that  comparatively 
early  date,  that  conditions  might  easily  arise  under 
which  the  subtreasury  sj'stcm  would  not  be  feasible. 
It  was  seen  that,  should  there  be  a  heavy  surplus,  it 


404  BANKING  AND  BUSINESS 

would  inevitably  operate  to  draw  out  of  the  circulation 
and  out  of  the  banks  a  substantial  percentage  of  the 
money  of  the  country,  retiring  it  from  use  until  such 
time  as  the  government  should  see  fit  to  pay  it  out 
again  in  the  ordinary  course  of  its  business.  Because 
the  amount  of  government  transactions  was  not  very 
large,  and  because  taxes  were  correspondingly  light, 
while  a  fair  adjustment  of  revenue  to  expenditure  had 
been  obtained,  this  was  not  an  immediate  or  pressing 
question,  but  every  observer  closely  familiar  with  the 
conditions  recognized  that  such  a  situation  might 
easily  develop,  and  that  the  subtreasury  system  would 
then  become  an  extremely  difficult  means  of  managing 
the  fiscal  affairs  of  the  government.  The  Civil  War, 
therefore,  found  the  government  with  its  fiscal  system 
entirely  divorced  from  the  banking  system  of  the 
country  and  with  the  banks  disorganized  and  subject 
to  no  uniform  or  joint  control. 

At  the  opening  of  the  Civil  War  it  was  promptly 
seen  that  very  definite  fiscal  expedients  would  have  to 
be  adopted.  The  customs  duties  fell  off  as  soon  as  the 
war  came  on,  and,  as  these  had  been  the  principal  source 
of  revenue,  the  federal  administration  was  sadly  in  need 
of  funds.  It  undertook  to  borrow  money  from  the 
banks,  and  then,  although  Congress  had  gi*anted  per- 
mission to  suspend  the  Independent  Treasury  Act  in 
certain  respects,  the  administration  insisted  on  draw- 
ing out  the  installments  of  the  loan  from  the  banks 
which  had  agreed  to  make  it.  The  banks  had  expected 
that,  instead  of  being  compelled  by  the  Treasury  to 
pay  coin  as  they  would  under  ordinary  circumstances 
have  had  to  do,  they  would  be  allowed  to  keep  the 
funds  on  deposit  in  their  vaults  and  simply  transfer 
them  at  the  government's  order  to  public  creditors. 
The  effect  of  drawing  off  the  specie  from  the  banks  and 
placing  it  in  the  Treasury  was  to  weaken  the  reserves 


AMERICAN   BANKING   SYSTEM      405 

and  finally  to  lead  to  a  suspension  of  specie  payments, 
the  banks  refusing  to  pay  out  gold  or  silver  on  demand. 

Meanwhile  the  necessities  of  the  govermnent  had 
been  mounting  very  rapidly,  and  it  had  been  unwisely 
determined  to  issue  legal-tender  Treasuiy  notes  (popu- 
larly known  as  "greenbacks").  The  first  issue  of  these 
notes  came  out  in  18G2  and  was  followed  by  other  issues. 
As  the  notes  were  legal  tender  they  could  be  used  in 
redeeming  bank  notes.  They  took  the  place  of  gold 
and  silver  coin,  these  metals  being  retii-ed  from  circu- 
lation and  hoarded  or  exported.  The  result  was  that 
the  country  was  speedily  placed  on  a  basis  of  irredeem- 
able paper.  It  was  now  without  a  metallic  circulation, 
without  any  large  financial  institution  on  which  to  fall 
back,  without  any  unifoim  bank-note  currency,  and 
without  any  substantial  control  over  the  banks.  The 
constant  and  enormous  demand  for  funds  with  which  to 
carry  on  the  war  could  not  be  satisfied  by  any  other 
means  than  huge  loans  on  long  time,  accompanied  by 
heavy  taxation  designed  to  supply  the  funds  for  paying 
the  interest  on  the  bonds  and  ultimately  redeeming 
them  as  they  fell  due.  In  endeavoring  to  sell  such 
bonds  the  federal  goverrmient  encountered  lamentable 
difficulty  and  was  driven  to  various  expedients  for 
pushing  the  securities  into  the  hands  of  buyers. 

Among  other  schemes  that  suggested  themselves  to 
the  Treasury  authorities  was  that  of  organizing  a  bank- 
ing system  similar  to  the  free  banking  system  of  the 
state  of  New  York.  The  basic  idea  of  this  system  was 
that  of  allowing  the  banks  to  issue  not«s,  on  condition 
that  they  should  deposit  with  the  Treasury  securities  in 
proj)er  amount  to  protect  the  notes  they  issued.  It 
was  supposed  that  by  reciuiring  them  to  buy  United 
States  bonds  to  serve  in  this  capacity,  the  government 
might  create  a  strong  demand  for  such  bonds  and 
that,  as  a  result,  it  would  be  found  easier  to  sell  the 


406  BANKING  AND   BUSINESS 

securities,  while  their  pricr.  would  probably  be  pro- 
portionately better. 

On  the  other  hand,  it  was  argued,  this  system  would 
be  so  popular  that  the  state  banks  would  be  unable 
to  compete  with  it.  They  would  rush  into  the  system, 
and  consequently  the  country  would  be  supphed  with 
a  uniform  currency,  issued  by  a  set  of  banks  directly 
under  the  control  of  the  national  government,  respon- 
sible to  that  government  and  purchasing  its  bonds  as  a 
basis  for  the  issue  of  its  notes.  This  was  the  funda- 
mental idea  upon  which  the  present  national  banking 
system  was  based.  It  was  designed  primarily  as  a 
device  of  national  finance  rather  than  as  a  service  to 
industry. 

IV.  National  Bank  Act. 

The  first  Act  "to  provide  a  national  currency  secured 
by  a  pledge  of  United  States  stock  and  to  provide  for 
the  circulation  and  redemption  thereof"  became  a 
law  February  25,  1863.  This  was  found  defective  in 
some  particulars  and  was  amended  during  the  following 
year.  The  Act  contained  most  of  the  pro\dsions  which 
had  been  found  necessary  in  the  experience  ^dth  state 
banks  during  preceding  years.  It  pro^dded  for  inspec- 
tion and  examination  on  the  part  of  the  federal  govern- 
ment through  a  currency  bureau ;  for  the  maintenance 
of  reserves,  the  redemption  of  notes  over  the  counter 
of  the  issuing  bank  and  at  agencies  in  certain  principal 
cities;  for  the  conversion  of  state  banks  into  national 
banks;  for  the  deposit  of  public  moneys  in  banks,  when 
necessary,  upon  security  of  United  States  bonds;  for 
the  taxation  of  the  banks,  and  numerous  other  points, 
some  of  the  more  important  of  which  have  already  been 
mentioned  in  foregoing  discussions. 

The  striking  feature  of  the  Act  was  seen  in  the  pro- 


AMERICAN   BANKING   SYSTEM      407 

visions  which  controlled  the  objects  for  which  it  had 
been  created  and  which  governed  the  methods  of  note 
issue  in  a  certain  degree.  The  banks  were  required  to 
buy  government  bonds  as  an  incident  to  their  receiving 
charters.  At  least  25  per  cent  of  the  amount  of  the 
capital  had  to  be  put  into  government  bonds  by  the 
smallest  class  of  banks.  This  requirement  became 
smaller  as  the  capital  of  the  bank  became  larger,  and 
in  the  large  banks  the  amount  of  bonds  bought  was  a 
comparatively  small  percentage  of  the  capitahzation. 
Notes  could  be  issued  to  the  amount  of  90  per  cent 
of  the  par  value,  but  not  exceeding  the  market  value  of 
the  bonds  held  by  the  institution,  such  bonds  being  in 
any  event  deposited  in  trust  with  the  Treasury  Depart- 
ment. The  amount  of  notes  to  be  issued  in  the  aggre- 
gate was,  however,  limited  to  $300,000,000,  and  this 
amount  was  apportioned  to  the  several  states  accord- 
ing to  population  and  existing  banking  conditions. 

With  the  comparatively  rigid  restrictions  imposed 
by  the  Bank  Act,  with  the  requirement  that  bonds  be 
purchased,  and  with  the  necessity  incumbent  upon 
state  banks  that  they  change  their  names  before  enter- 
ing the  system,  the  existing  institutions  were  some- 
what slow  to  give  up  their  old  charters  and  reorganize 
under  the  national  law.  The  effect  of  this  hesitation 
was  to  prevent  the  banks  from  rushing  into  the  new 
system  as  they  had  been  expected  to.  Lat«  in  1864 
there  were  only  584  banks  in  the  system,  and  they  had 
outstanding  a  circulation  of  only  S65,000,000.  The 
results  which  were  expected  in  the  way  of  a  demand  for 
United  States  bonds  originating  with  the  national 
banks  were  consequently  not  realized. 

The  national  banking  system  did  not  materially  in- 
fluence the  demand  for  bonds,  but  the  advantages 
arising  out  of  the  creation  of  a  uniform  currency  were 
more  and  more  generally  recognized,  and  various  ad- 


408  BANKING  AND   BUSINESS 

ministrators,  who  at  first  had  opposed  the  plan,  became 
advocates  of  it.  Some  went  so  far  as  to  urge  that 
legislation  be  adopted  whereby  state  banks  would 
practically  be  compelled  to  cease  issuing  notes,  and  in 
harmony  with  such  recommendations  Congress  in  the 
Act  of  March  3,  1865,  imposed  a  tax  of  10  per  cent 
on  state-bank  issues,  beginning  with  July  1,  1866. 
Thereafter  the  banks  came  into  the  system  much  more 
rapidly,  and  there  was  a  considerable  drift  away  from 
the  state  banking  systems.  It  was  speedily  perceived, 
however,  that  the  state  systems,  even  without  the 
power  to  issue  notes,  had  a  place  of  their  own.  Some 
of  the  strongest  state  banks  preferred  to  retain  their 
charters  under  state  laws  and  to  go  on  doing  a  discount 
and  deposit  business. 

V.  Development  of  the  National  Banking  System. 

The  power  to  control  note  issues,  and  the  prestige 
resulting  from  federal  supervision,  however,  gave  the 
national  banks  the  lead,  and  from  1866  onward  they 
were  rapidly  organized,  extending  into  the  South  as 
soon  as  the  Civil  War  had  closed.  Great  difficulty 
was  experienced  in  consequence  of  the  limitation  of 
the  note  issues  to  $300,000,000  in  the  aggregate.  In 
1866  the  national-bank  circulation  amounted  to  about 
$280,000,000.  This  sum  was  very  badly  distributed. 
The  wealthier  and  older  parts  of  the  North  had  secured 
a  large  share  of  the  notes.  In  New  England  much 
more  than  the  due  proportion  belonging  to  them  had 
been  acquired  by  the  banks,  while  the  South  was  un- 
able to  get  much  currency,  notwithstanding  that  it 
was  sorely  in  need  of  some  notes  to  take  the  place  of 
the  Confederate  currency  which  had  driven  out  specie. 
The  maximum  limitation  had  been  set  partly  because 
Congress  feared  that  in  a  time  of  suspension  of  specie 


AMERICAN   BANKING   SYSTEM      409 

payments  such  as  then  existed  throughout  the  country, 
permission  to  issue  notes  up  to  any  amount  of  bonds 
that  the  banks  might  deposit  (not  exceeding  their 
capital)  might  lead  to  an  overissue  of  bank  notes, 
which  would  operate  still  further  to  postpone  the  date 
of  redemption. 

The  national  government  was,  therefore,  not  willing 
to  relieve  the  shortage  of  currency  by  removing  the 
limitation,  but  finally  sought  to  help  matters  somewhat 
by  enlarging  the  maximum  limitation  to  $354,000,000, 
while  it  was  further  provided  that  $25,000,000  should  be 
withdrawn  from  those  states  that  had  more  notes 
than  their  share  and  issued  to  banks  and  states  which 
had  less  than  their  share.  The  provision  was  so  com- 
plex, and  the  rate  of  interest  was  so  high  in  the  South 
and  West  as  compared  with  the  comparatively  low 
interest  earned  on  the  bonds  which  had  to  be  deposited 
in  order  to  get  the  notes,  that  there  was  relatively  little 
disposition  on  the  part  of  the  Southern  and  Western 
banks  to  act  under  the  law  of  1870.  In  fact,  this 
demand  was  so  slack  that  it  did  not  prove  necessary 
to  withdraw  the  $25,000,000  in  notes  from  banks  that 
had  more  than  their  proportionate  share. 

When  Congress  finally  got  to  the  point,  in  1875, 
where  it  felt  able  to  provide  for  the  resumption  of 
specie  payments,  it  also  dealt  with  the  bank-note 
question  by  repeahng  all  limitations  upon  the  issue  of 
bank  notes  to  any  amount,  sul^ject  to  the  general 
limitations  and  requirements  of  the  law  with  reference 
to  bonds  and  capital.  This  change  helped  the  situa- 
tion considerabl}'.  There  was  a  decided  increase  in 
the  development  and  ])ros])erity  of  the  national  system, 
and,  on  the  other  hand,  a  decided  gi'owth  of  opposition 
sjirang  up.  The  system  was,  however,  by  this  time 
thoroughly  well  established,  and,  after  the  resumption 
of  specie  payments  in  1879,  the  notes  of  the  banks  were 


410  BANKING  AND   BUSINESS 

equivalent  in  value  to  gold,  and  provided  an  unques- 
tionably stable  and  satisfactory  currency  so  far  as 
questions  of  safety  and  security  were  concerned. 
Changes,  however,  had  occurred  in  the  fundamental 
basis  upon  which  the  national  banking  system  was 
founded,  and  the  result  was  a  tendency  to  decrease  the 
amount  of  circulation  outstanding. 

As  has  been  seen,  the  banks  were  required  to  deposit 
$100  in  bonds  for  every  $90  which  they  received  in 
notes.  Supposing  the  bonds  employed  for  this  purpose 
bore  6  per  cent,  it  is  plain  that  a  bank  that  had  $100 
in  gold  coin  or  other  legal-tender  money  could  (if  the 
bonds  were  at  par)  buy  $100  in  bonds,  thus  getting 
6  per  cent  interest  thereon,  deposit  the  amount  with 
the  Secretary  of  the  Treasury,  receive  back  $90  in 
notes,  and  then  lend  these  notes  to  borrowers  at  such 
a  rate  of  interest  as  they  were  willing  to  pay.  The 
following  of  this  plan  led  in  some  quarters  to  the 
bringing  forward  of  an  argument  now  very  famihar — 
that  banks,  by  reason  of  the  bond  deposit  system,  were 
able  to  make  a  "double  profit,"  inasmuch  as  they  got 
the  interest  on  the  bonds  and  the  interest  on  the  notes. 

As  a  matter  of  fact,  there  was  no  foundation  for  this 
complaint.  A  ''double"  profit  is  what  every  banker 
has  to  make  in  order  to  pay  the  special  expenses  of 
banking,  otherwdse  he  might  as  well  use  his  capital 
in  loans  on  real  estate  or  other  security.  If  the  banker 
had  $100  in  gold  to  start  with,  he  would  do  very  much 
better  for  himself  were  he  to  use  the  cash  as  a  reserve 
and  simply  make  his  loans  by  granting  credits  on  his 
books  than  he  would  were  he  to  follow  the  plan  of 
buying  bonds  and  getting  notes  to  be  loaned.  In 
practice,  if  the  banker  were  able  to  lend  foui'  times  the 
amount  of  his  reserve  he  would  get  the  interest  on 
$400  of  loans  and  maintain  a  reserve  of  $100  in  coin, 
while  in  the  national  system,  if  he  took  out  notes  he 


AMERICAN   BANKING   SYSTEM      411 

would  get  the  interest  on  $100  in  bonds  and  S90  in 
notes,  even  if  he  did  not  have  to  supply  a  reserve 
behind  these  notes — which,  of  course,  he  would  be 
obhged  to  do,  either  in  the  form  of  a  redemption  fund 
with  the  Treasury  or  as  a  cash  reserve  in  his  vaults. 

It  is  obvious  that  the  higher  the  price  of  the  bonds 
went,  the  less  would  be  the  profit  to  be  derived  from 
notes,  since,  under  the  original  National  Act,  the  banks 
could  get  only  90  per  cent  of  the  par  value.  Thus,  if 
bonds  stood  at  125  it  is  clear  that  the  banker  would 
have  to  spend  $125  in  order  to  get  a  bond  whose  par 
value  was  $100  and  on  the  strength  of  which  he  could 
get  only  $90  in  notes.  This  would  mean  that  there  was 
a  margin  of  $35  between  the  amount  paid  for  the  bond 
and  the  amount  of  notes  obtained,  on  which  there  was 
no  return.  During  the  years  after  1870,  the  price  of 
bonds  steadily  rose,  and  this  process  was  accelerated 
after  1875,  when  resumption  was  decided  on. 

A  further  influence  tending  to  stimulate  the  price  of 
bonds  came  from  the  redemption  of  portions  of  the  debt 
out  of  surplus  revenues.  Not  only  did  the  issue  of 
circulation  become  less  profitable  to  the  banks,  but  they 
also  saw  opportunities  for  making  a  substantial  profit 
by  selling  their  bonds  at  the  higher  prices  that  had 
become  the  rule.  Under  the  influence  of  these  con- 
ditions, the  national  circulation,  which  had  risen  to 
about  $350,000,000  at  the  end  of  1873,  fell  off  nearly 
$50,000,000  during  the  succeeding  three  years.  Sub- 
sequently there  was  a  slight  expansion,  and  then 
the  reactionary  movement  set  in  once  more.  In 
1879 — the  resumption  year — the  circulation  was  only 
$323,000,000. 

Congress  was  now  under  the  influence  of  the  anti- 
banking  sentiment  which  had  developed  throughout 
the  country,  and  in  1881  passed  a  bill  requiring  3-per- 
cent bonds  which  were  to  be  issued  for  the  purpose  of 


412  BANKING  AND   BUSINESS 

refunding  the  national  debt  to  be  used  by  the  banks  as 
security  for  circulation.  Other  provisions  in  the  Act 
would  have  made  it  difficult  or  impossible  to  reduce 
circulation  any  further,  and  the  result  was  a  sharp 
retirement  of  notes  in  anticipation  of  the  passage  of 
the  law.  The  measure  was  vetoed,  but,  while  a  good 
many  bonds  that  had  been  withdrawn  were  redeposited, 
the  movement  toward  the  curtailment  of  circulation 
had  now  definitely  begun. 

VI.  Growth  of  a  Government  Surplus. 

The  curtailment  of  bank  currencj'-  under  the  national 
system  which  had  started.,  in  consequence  of  the  natural 
causes  already  set  forth,  which  grew  out  of  the  greater 
prosperity  of  the  country  and  the  more  stable  condition 
of  its  finances,  was  now  to  be  still  further  aided  as  a 
result  of  the  growth  of  a  great  government  surplus. 
The  Treasury  had  been  buying  bonds,  and  thereby 
reducing  indebtedness,  during  the  later  'seventies  as 
occasion  offered.  But  the  process  went  forward  even 
more  rapidly  after  1880.  Revenues  were  abundant  and 
largely  in  excess  of  the  amount  needed  for  government 
expenses.  Consequently,  under  the  independent  Treas- 
ury law  whose  features  have  already  been  noted,  only 
two  uses  could  be  made  of  these  excess  funds.  Thej^ 
might  be  kept  on  hand  in  money  in  the  vaults  or  they 
might  be  deposited  with  the  banks.  The  latter  opera- 
tion, however,  necessitated  the  depositing  of  govern- 
ment bonds  with  the  Treasury  as  security. 

It  was  found  that  if  the  Treasury  used  the  surplus 
funds  to  buy  up  issues  of  bonds  in  the  market  before  they 
were  due,  it  raised  the  price  of  the  bonds  so  high  that  it 
became  expedient  for  the  national  banks  to  sell  as  many 
of  their  bonds  as  they  could  and  reduce  their  circulation 
to  as  low  a  point  a&  possible,  while  if  the  funds  were 


AMERICAN  BANKING   SYSTEM      413 

deposited  in  the  banks  the  latter  were  obliged  to  buy 
the  bonds  in  order  to  use  them  as  security  with  the 
Treasury  for  the  holding  of  the  deposits.  They  thus 
raised  the  price  of  the  bonds  in  the  market  through  their 
own  action,  and  made  it  unprofitable  for  themselves 
to  use  such  bonds  for  the  maintenance  of  outstand- 
ing circulation.  During  the  years  1881-91  the  bonded 
debt  of  the  United  States  was  cut  by  more  than 
$1,000,000,000.  The  price  of  the  bonds  rose  tremen- 
dously, and  in  1891  the  lowest  average  price  was  more 
than  124.  The  effect  of  these  changes  was  very  soon 
perceived  in  the  national-bank  circulation,  which 
dropped  from  $323,000,000  in  1879  to  $173,000,000  in 
1892.  It  almost  seemed  as  if  the  issue  of  notes  would 
be  cut  to  the  absolute  minimum  corresponding  to  the 
\'olume  of  bonds  required  by  the  law  to  be  deposited  as 
a  prerequisite  to  the  existence  of  the  banks. 

New  conditions  set  in  after  1890.  The  Tariff  Act 
of  that  year  had  been  so  drafted  as  to  cause  a  large 
decrease  in  the  annual  net  revenue,  and  it  was  shortly 
apparent  that,  instead  of  having  funds  with  which  to 
buy  more  bonds,  the  government  would  have  to  borrow 
money  on  new  bonds.  Conditions  were  complicated 
by  the  silver-purchase  poHcy  which  had  been  followed 
by  the  government  since  1878  and  which  was  carried 
farther  by  the  silver-purchase  law  of  1890.  This 
policy  contributed  to  the  panic  of  1893,  although  the 
silver-purchase  law  was  repealed  in  that  year.  Issues 
of  new  bonds  were  made  by  the  government  during  the 
second  Cleveland  administration  (1893-97),  to  the 
amount  of  some  $252,000,000.  This  and  the  cessation 
of  the  silver-purchase  poUcy  and  of  the  issues  of  notes 
based  on  silver  by  the  government  somewhat  helped 
the  bank  circulation  to  increase,  and  in  189(5  the  total 
notes  outstanding  had  grown  to  about  $214,000,000. 


CHAPTER   XXV 

ORGANIZATION   OF  THE   FEDERAL  RESERVE   SYSTEM  i 

I.  Defects  in  the  National  Banking  System. 

Deficiencies  in  the  national  banking  system  were 
perceived  comparatively  early  in  its  history,  but  did 
not  make  themselves  felt  in  a  way  so  serious  as  to  enlist 
active  effort  for  their  correction  until  about  twenty- 
five  years  after  the  system  had  first  become  operative. 
Moreover,  during  this  period  of  twenty-five  years  the 
difficulties  which  were  most  seriously  felt  w^ere  not  those 
that  afterward  caused  most  annoyance  and  led  to  most 
active  effort  for  improvement.  Probably  the  first  in- 
convenience that  was  experienced  in  the  management 
of  the  national  circulation  after  the  national  banking 
system  had  been  definitely  created  and  the  Act  had 
been  amended  to  meet  the  earlier  requirements  of  the 
conditions  then  existing,  was  the  prospect  that  the 
supply  of  government  bonds  available  at  prices  that 
would  enable  the  banks  to  put  out  circulation  based 
thereon  would  be  insufficient.  In  1880-83  this  prob- 
lem, as  seen  at  an  earlier  point,  had  become  acute,  the 
twenty-year  bonds  which  had  been  issued  by  the  federal 
government  during  the  Civil  War  at  5  and  G  per  cent 
interest  expiring,  and  the  question  what  should  be 
done  in  connection  with  them  being  unsettled.  The 
problem  was  disposed  of  by  refunding  the  bonds  for 
another  twenty  years  and  thus  enabling  the  national 
banks  to  get  the  securities  they  needed  as  a  basis  for 

^  Adopted  in  part  from  "The  Federal  Reserve"  by  H.  P.  Willis,  by 
permission  of  the  publishers,  Messrs.  Doubleday,  Page  &  Co. 


ORGANIZATION 

OF  THE 

FEDERAL   RESERVE   SYSTEM 


FEDERAL 

RESERVE 

BOAR  O 


CHAIRMAN  EX  OFFICIO 


MEMBER  EX  OFFICIO 


GOVERNOR 


VICE  GOVERNOR 


FEDERAL 
ADVISORY 
COUNCIL 


StCBn«RYOFTHt  IBEASURY    hi 
^COMPTROLLEB  OF  THE  CURRENg  W 


FEDERAL  RESERVE  BANK' 
BOARD  OF  DIRECTORS 


-fr 

R 

1 — ^~\ 

BANKING 

eusmcss 

umif 

..... 

ClutlMUl 

..... 

CONFERENCE 

OF 

AGENTS 


'- ' J 


MEMBER   BANKS 
LARGE 


EXrUMAIORr  UY 

Appouitso)  titan 

B«loa|t  lo 


CONFERENCE 
OF 

GOVERNORS 


FEDERAL   RESERVE   ORGANIZATION    415 

their  circulation.  With  the  growth  of  the  great  sur- 
pluses of  revenue  during  the  decade  1880-90,  a  new 
type  of  problem  appeared ;  for  the  purchases  made  by 
the  Treasury  Department,  in  order  thus  to  use  up  the 
surplus,  had  brought  the  bonds  to  a  premium  and  made 
it  questionable  whether  the  maintenance  of  the  circu- 
lation on  a  satisfactory  basis  providing  for  the  issue  of 
enough  of  the  notes  would  be  feasible.  Discussion  of 
the  question  was,  however,  only  sporadic.  The  na- 
tional system  was  proving  itself  in  so  many  ways 
better  adapted  to  the  needs  of  the  country  than  the 
system  of  banking  which  had  preceded  it,  that  compara- 
tively few  persons  were  disposed  to  attack  it  seriously. 
The  difficulty  in  getting  an  adequate  supply  of  notes 
had  been  making  itself  more  and  more  felt  prior  to 
that  time,  and  when  the  panic  of  1893  came  on  this 
phase  of  the  problem  became  suddenly  very  acute. 
During  the  panic  of  1893  there  was  a  tremendous 
shortage  of  currency  and  many  expedients  had  to  be 
resorted  to  for  the  purpose  of  supplying  even  the  bare 
necessities  of  the  country  for  a  circulating  medium. 
Not  only  clearing-house  certificates,  but  a  great  variety 
of  forms  of  local  obligations  which  serve  as  currency 
substitutes,  were  injected  into  the  circulation  from 
time  to  time,  and  served  as  a  means  of  relieving  the 
strain  upon  national-bank  notes.  As  for  the  national- 
bank  notes  themselves,  it  was  almost  out  of  the  ques- 
tion to  obtain  sufficient  amounts  of  them.  Even  when 
a  national  bank  had  deposited  its  bonds  with  the 
Treasury  and  had  made  application  for  notes,  fully 
three  weeks  were  necessary  in  order  to  get  delivery 
of  the  finally  complct<3d  cun-ency.  This  delay  was 
necessary  in  order  that  the  notes  might  l)e  printed, 
dried,  and  shij^ped  to  their  destination.  The  process 
of  signing  them  and  jiutting  them  out  required  more 
time.     Altogether,  the  delay  involved  in  makhig  the 


416  BANKING  AND   BUSINESS 

currency  available  was  so  great  that  the  experience  of 
the  panic  convinced  practically  all  observers  of  the 
unsatisfactory  nature  of  the  prevailing  system  for 
issuing  notes  as  a  practical  matter,  entirely  independent 
of  the  question  whether  the  method  of  note  issue  pro- 
vided in  the  National  Act  was  or  was  not  theoretically 
satisfactory  or  desirable. 

II.  The  Baltimore  Plan. 

The  result  of  these  events  was  to  draw  the  attention 
of  American  bankers  toward  the  practice  of  other 
countries.  Many  persons  believed  that  the  past 
experience  of  the  United  States  with  so-called  central 
banking,  as  exempUfied  in  the  history  of  the  First  and 
Second  banks  of  the  United  States,  had  been  such  as 
practically  to  put  resort  to  such  expedients  out  of  the 
question.  The  Canadian  Bank  Act,  which  had  been 
lately  revised,  offered  as  its  most  striking  feature, 
from  the  standpoint  of  American  bankers,  an  issue 
of  currency  protected  by  a  joint  guaranty  fund  con- 
tributed by  all  of  the  banks.  At  a  meeting  of  the 
American  Bankers'  Association  in  1894,  at  Baltimore, 
a  plan  of  a  somewhat  similar  sort  was  advocated.  This 
was  designated  as  the  ''Baltimore  Plan,"  and  became 
to  many  minds  synonymous  with  what  has  long  been 
called  "currency  reform."  Unsatisfactory  conditions 
in  the  currency  situation  had  their  share  in  contributing 
to  the  growth  of  the  silver  agitation,  but  the  presiden- 
tial campaign  of  1896  turned  almost  entirely  about  the 
question  of  remonetizing  silver.  Discussion  of  banking 
and  currency,  as  distinct  from  that  relating  to  the 
standard  of  value  for  money,  practically  disappeared  in 
the  struggle  over  silver.  Immediately  after  the  elec- 
tion of  President  McKinley,  however,  an  effort  was 
made  by  business  men  and  bankers  throughout  the 


FEDERAL   RESERVE   ORGANIZATION     417 

country  to  direct  attention  once  more  toward  the  ques- 
tion of  an  appropriate  note  issue.  Legislative  leaders, 
nevertheless,  showed  almost  complete  indifference  to 
the  whole  subject,  and  the  ''currency  reform"  move- 
ment after  189G,  therefore,  naturally  became  an  effort 
to  secure  definite  gold-standard  legislation,  and  only 
incidentally  improvement  of  the  banking  situation. 

III.  Indianapolis  Currency  Commission. 

The  most  notable  movement  of  the  four  years  from 
1896  to  1900  was  that  embodied  in  what  was  called 
the  Indianapolis  Currency  Commission.  This  was  a 
body  appointed  by  a  convention  of  boards  of  trade 
and  commercial  organizations  generally,  which  had 
met  at  Indianapolis,  Indiana.  The  commission  did  its 
work  largely  in  Washington,  and  ultimately  issued  a 
report  which  called  for  three  principal  changes  in  exist- 
ing legislation:  (1)  The  definite  establishment  of  the 
gold  standard;  (2)  the  separation  of  the  gold  fund  pro- 
tecting greenbacks  or  United  States  notes  in  the  Treas- 
ury Department  from  the  other  funds  of  the  Treasury, 
with  provision  for  reconstituting  this  fund  by  the  issue 
of  bonds;  and  (3)  the  issue  of  bank  notes  based  upon 
commercial  paper  and  duly  protected  in  various  ways. 

IV.  Gold  Standard  Act. 

It  is  probable  that  this  report  would  have  evoked 
immediate  action  by  Congress  to  some  effect  had  not 
the  Spanish- American  War  intervened.  The  close  of 
the  war  found  the  United  States  approaching  another 
presidential  election.  Congressional  leadei'S  then  has- 
tily framed  a  measure  known  as  the  gold-standard  law 
of  1900,  which  became  a  statute  on  March  14th  of  that 
year.  In  this  gold-standard  law  provision  was  made 
for  the  segregation  of  the  funds  of  the  Treasury,  so  that 


418  BANKING  AND  BUSINESS 

$150,000,000  should  always  be  available  behind  the 
greenbacks,  and  authority  was  given  to  the  Secretary 
of  the  Treasury  to  sell  bonds  for  the  purpose  of  re- 
establishing this  fund  if  at  any  time  it  should  fall 
below  $100,000,000  fixed  for  it.  The  Act  declared 
the  standard  of  money  in  the  United  States  to  be 
the  gold  dollar,  although  it  was  defective  in  mak- 
ing no  provision  for  the  redemption  of  the  silver  dollar  in 
gold  or  for  the  issue  of  bonds  to  maintain  parity.  Out- 
standing bonds  were  to  be  refunded  into  2-per-cent  con- 
sols, and  these  2-per-cent  bonds  were  made  available  to 
protect  national-bank  currency.  Prior  to  1900,  $50,000 
had  been  the  minimum  capitalization  of  a  national  bank, 
but  the  new  Act  reduced  this  sum  to  $25,000  in  towns 
of  3,000  inhabitants.  This  reduction  and  the  issue  of 
the  2-per-cent  bonds  were  expected  to  enable  country 
communities  to  organize  national  banks  and  take  out 
the  currency  they  needed.  The  fact  that  prior  to 
1900  the  outstanding  bonds  had  brought  a  large 
premium,  while  banks  could  obtain  only  90  per  cent 
of  the  par  value  of  their  bonds  in  currency,  had  made 
it  unprofitable  for  the  banks  to  issue.  For  example, 
if  a  bank  had  to  pay  for  $100,000  of  government  bonds, 
say,  $112,000,  while  it  could  get  only  $90,000  in  cur- 
rency, there  would  be  a  gap  of  $22,000  between  the 
currency  and  the  amount  invested  in  bonds,  on  which 
the  bank  was  likely  to  suffer  loss.  Shrinkage  in  bond 
premiums  and  the  fact  that  this  amount  of  money  was 
not  definitely  employed  in  any  way,  except  for  the  inter- 
est on  the  face  of  the  bonds,  made  the  issue  unsatisfac- 
tory to  the  banks.  Therefore  the  new  law  allowed 
the  banks  to  get  in  notes  100  per  cent  of  the  face  of 
their  bonds  or  market  value  if  below  par.  The  Act  of 
1 900  made,  however,  no  provision  whatever  for  notes 
based  on  commerical  paper,  nor  did  it  render  the  prompt 
issue  of  the  notes  any  easier  than  before.  It  was  never- 


FEDERAL  RESERVE  ORGANIZATION   419 

theless  successful  in  stimulating  the  organization  of 
national  banks,  and  the  number  in  existence  rapidly 
increased,  especially  in  the  group  with  $25,000  capital. 
The  outstanding  bonds  were  rapidly  converted  into  the 
new  2-per-cent  bonds,  and  these  were  taken  up  by  the 
new  banks.  The  small  banks,  especially,  were  disposed 
to  take  out  circulation  up  to  the  level  allowed  by  law, 
and  became  strong  buyers  of  2-per-cent  bonds. 

Under  the  Act  of  1900  the  needs  of  the  country  for 
currency  were  more  or  less  fully  met.  Business  was 
prosperous  and  there  was  a  general  expansion  of  opera- 
tions and  of  prices.  The  Act  of  1900  had  not,  however, 
met  any  of  the  real  requirements  of  banking  and  cur- 
rency reform.  Although  the  previous  prosperity  and 
the  apparent  remoteness  of  panic  had  led  to  a  slacken- 
ing of  interest  on  the  part  of  many  commercial  and 
business  interests  which  had  previously  urged  banking 
reform,  scientific  students  of  the  situation  did  not 
reduce  their  efforts,  and  nearly  every  year  a  succession 
of  new  bills  made  their  appearance  in  Congress.  The 
striking  feature  of  this  second  period  of  agitation  may 
be  said  to  be  the  recognition  of  the  fact  that  a  mere 
reform  in  note-currency  issue  methods  would  not  meet 
the  needs  of  the  case.  Both  the  experience  of  foreign 
countries  and  of  the  United  States,  as  well  as  closer 
analysis  of  the  contemporary  experience  of  Canada, 
showed  that  such  was  the  fact,  and  emphasized  the 
necessity  for  a  more  thorough  and  far-reaching  type 
of  legislation  than  had  yet  been  afforded. 

V.  Effect  of  Panic  of  1907. 

Notwithstanding  the  apparent  prosperity  of  the 
country,  there  were  signs  of  danger  in  the  inflation  and 
unsound  finance  that  prevailed  during  the  period,  and 
these,  at  about  the  beginning  of  the  year  1907,  had 


420  BANKING  AND  BUSINESS 

developed  into  a  state  of  affairs  which  portended  im- 
mediate disaster.  Banks  were  greatly  inflated  with 
large  lines  of  credit  which  they  could  not  liquidate. 
Business  men  were  unable  to  pay  their  obhgations.  In 
the  late  summer  it  appeared  inevitable  that  there 
would  be  a  collapse,  and  this,  in  fact,  occurred  in 
October.  The  first  open  symptom  of  difficulty  was 
noticed  in  New  York,  and  from  there  the  trouble 
steadily  spread  throughout  the  country.  As  usual, 
specie  payments  were  suspended  and  clearing-house 
certificates  were  issued.  There  was  a  general  shortage 
of  currency,  accompanied  by  many  bank  failures.  In 
order  to  reheye  the  situation.  Secretary  of  the  Treasury 
Cortelyou  and  Comptroller  of  the  Currency  Ridgely 
did  all  in  their  power  to  enlarge  the  volume  of  bonds 
available  for  the  purpose  of  carrying  the  new  national- 
bank  notes.  At  the  opening  of  the  panic  it  seemed  as 
if  all  the  available  bonds  had  already  been  deposited 
with  the  Treasury  to  secure  national-bank  notes  or  else 
to  protect  public  deposits.  As  pubhc  deposits  with 
banks  were  then  very  large,  the  amount  of  bonds  thus 
rendered  unavailable  as  a  basis  for  bank-note  issue 
was  likewise  considerable.  The  Treasury  Department 
ruled  that  other  securities  might  be  substituted  for 
national  bonds  behind  public  deposits,  and  this  released 
a  good  many  national  bonds,  which  were  then  trans- 
ferred to  circulation  account,  thereby  pro\dding  for  the 
issue  of  an  additional  supply  of  notes.  In  this  way 
considerable  enlargement  of  the  circulation  was  ob- 
tained, but,  as  on  former  occasions,  the  assistance  came 
too  late  to  do  very  much  good. 

VI.  The  Aldrich  Bill. 

It  was  strongly  felt  that  Congress  ought  to  do  some- 
thing by  way  of  reUef,  particularly  as  another  presi- 


FEDERAL  RESERVE   ORGANIZATION     421 

dential  election  was  in  sight.  Consequently,  in  the 
spring  of  1908  a  bill  was  reported  by  the  House  Bank- 
ing and  Currency  Committee  and  another  by  the 
Senate  Committee  on  Finance.  The  House  bill  was  a 
measure  calling  for  the  issue  of  currency  based  on  com- 
mercial paper,  while  the  Senate  plan,  speedily  known 
as  the  Aldrich  bill,  sought  to  meet  the  difficulty  by 
allowing  banks  to  deposit  ^\'ith  the  Treasury  other 
kinds  of  bonds  in  protecting  their  circulation.  The 
philosophy  of  the  House  bill  was  more  complex,  being 
based  on  the  view  that  what  the  country  needed  was  a 
thorough  revision  of  its  banking  methods,  particularly 
as  related  to  the  issue  of  currency,  with  a  flexible  note 
issue  backed  by  commercial  paper.  By  a  legislative 
maneuver  there  was  now  substituted  for  the  original 
bill  a  plan  which  became  known  as  the  Vreeland  bill, 
and  called  for  the  issue  of  currency  by  associations  of 
banks,  called  at  first  clearing-house  associations  on  the 
basis  of  commercial  paper  deposited  with  such  asso- 
ciations. The  bill  was  originally  incredibly  crude,  and 
was  changed  almost  daily  for  a  long  period  of  time. 
It  finally  assumed  greater  feasibiUty  and  was  passed 
by  the  House  of  Representatives.  The  Aldrich  bill 
had  meanwhile  been  passed  in  the  Senate,  and  efforts 
were  now  made  to  adjust  and  combine  the  two.  Ulti- 
mately this  attempt  resulted  in  the  so-called  Aldrich- 
Vreeland  Act  of  May  30,  1908,  which  permitted  the 
issue  of  currency  based  on  conmiercial  paper  by  asso- 
ciations of  banks  known  as  "National  Currency  Asso- 
ciations," while  it  also  permitted  national  banks  to 
deposit  bonds  of  specified  classes  with  the  Treasury 
Department  and  to  receive  direct  issues  of  currency 
based  thereon.  In  every  case  the  new  currency  was 
made  the  subject  of  a  very  high  rate  of  taxation,  it 
being  supposed  that  this  would  force  the  notes  to  retire 
rapidly.     One  feature  of  the  Act  was  a  provision  for  a 


422  BANKING  AND   BUSINESS 

"National  Monetary  Commission"  to  consist  of 
Senators  and  Representatives  only.  The  commission 
was  given  almost  unlimited  power  of  spending  money  in 
furtherance  of  its  inquiry,  and  was  directed  to  investi- 
gate currency  and  banking  conditions  wherever  it  saw 
fit,  and  report  to  Congress  what  further  action  was 
needed. 

The  control  of  Congress  changed  in  1910,  a  Demo- 
cratic majority  appearing  in  the  House  of  Representa- 
tives, while  dissatisfaction  with  the  expenditures  of 
the  commission  for  traveling  and  pubUshing  began  to 
be  expressed.  Late  in  the  summer  of  1910  Senator 
Cummins  of  Iowa  succeeded  in  securing  the  adoption 
of  a  resolution  calling  for  some  report  by  the  Monetary 
Commission  within  a  specified  period.  In  December 
following  the  outlines  of  a  bill  drafted  for  Senator 
Aldrich  became  know^n  to  the  public,  and  shortly 
thereafter  the  measure  was  adopted  by  the  National 
Monetary  Conunission.  This  later  became  known  as 
the  Aldiich  bill. 

The  Aldrich,  or  IMonetary  Commission,  bill  was  a 
lengthy  and  detailed  legislative  proposal  which  had 
been  worked  out  with  the  aid  of  banking  authorities, 
and  which  presented  a  plan  for  the  complete  reorganiza- 
tion of  the  banking  system  of  the  country.  In  order 
to  understand  the  Aldrich  bill  thoroughly  it  must  be 
remembered  that,  as  already  suggested,  it  was  merely 
the  outcome  of  a  long  period  of  discussion  and  con- 
troversy. The  brief  treatment  to  which  we  are 
necessarily  limited  prevents  us  from  considering  more 
than  a  very  few  of  the  antecedents  of  the  bill ;  but  it  is 
important  to  note  that  the  measure  had  been  pre- 
ceded by  two  other  proposals  of  similar  character, 
which  had  been  worked  out  independently  of  those 
who  had  the  Aldrich  bill  in  hand.  These  were  the 
Fowler  and  the  Muhleman  bills.    A  true  understanding 


FEDERAL   RESERVE   ORGANIZATION     423 

of  the  Aldrich  bill,  and  what  was  done  in  the  way  of 
legislation  subsequently,  can  best  be  attained,  there- 
fore, by  a  brief  sketch  of  these  three  measures. 

The  object  of  the  plans  presented  in  these  three  pro- 
posed measures  was  that  of  arranging  a  co-operative 
organization  of  the  banks  of  the  United  States  which 
should  serve  to  afford  these  banks  the  means  of  re- 
discounting  their  paper  at  times  when  thej^  required 
assistance  or  accommodation  in  order  to  continue 
extending  loans  to  their  customers,  and  in  order  to 
avoid  the  curtailment  of  credit  which  in  the  past  had 
frequently  resulted  in  precipitating  commercial  panics 
and  stringency.  The  fundamental  idea  running  through 
the  proposals  was  that  of  centralizing  the  control  of 
discounts  as  well  as  that  of  applying  a  more  rigorous 
method  of  oversight  to  the  operations  of  the  several 
banks  expected  to  participate  in  the  new  scheme.  It 
was  supposed  by  the  authors  of  these  plans  that  the 
institution  which  they  aimed  to  create  would  accom- 
phsh  at  least  the  following  financial  results : 

1.  Establishment  of  a  more  or  less  uniform  rate  of 
discount  throughout  the  United  States,  and  thereby 
the  furnishing  of  a  certain  kind  of  control  over  bank 
operations  which  should  be  similar  in  all  parts  of  the 
country. 

2.  General  strengthening  of  reserves  in  order  that 
such  reserves  might  be  held  ready  for  use  in  protecting 
the  banks  of  any  section  of  the  countr}'-  and  so  enabhng 
them  to  go  on  meeting  their  obhgations  instead  of 
suspending  payments,  as  had  so  often  been  necessary 
in  the  past. 

3.  Furnishing  of  an  elastic  currency  by  the  abolition 
of  the  existing  bond-secured  note  issue  in  whole  or  in 
part,  and  the  substitution  of  a  freely  issued  and  ade- 
quately protected  system  of  bank  notes  which  should 

28 


424  BANKING  AND   BUSINESS 

be  available  to  all  institutions  which  had  the  proper 
class  of  paper  for  presentation. 

4.  Management  and  commercial  use  of  the  funds  of 
the  government  which  were  then  isolated  in  the  Treasury 
and  subtreasuries  in  large  amounts. 

5.  General  supervision  of  the  banking  business  and 
furnishing  of  more  stringent  and  careful  oversight. 

Other  objects  were  sought,  incidentally,  in  these  plans, 
but  they  were  not  as  fundamental  as  the  chief  purposes 
just  enumerated. 

The  plans  presented  a  general  community  of  design 
and  similarity  of  arrangement  which  was  not  necessarily 
the  outgrowth  of  plagiarism  or  imitation,  but  had 
resulted  from  the  facts  that  some  proposition  of  the 
same  general  kind  had  been  under  consideration  for 
many  years  previous,  and  had  commended  itself  to 
leading  bankers  and  business  experts,  and  that  the  idea 
of  combined  action  had  also  the  support  of  European 
experience,  nearly  every  European  country  being 
equipped  already  with  a  central  banking  mechanism  of 
some  kind.  This  notion  of  a  central  banking  mecha- 
nism which  should  economize  resources  and  sustain  the 
several  banking  units  was  thus  admittedly  desirable, 
provided  that  various  difficulties  connected  with  it 
could  be  overcome.  It  was  in  overcoming  these  dif- 
ficulties and  avoiding  the  embarrassments  that  neces- 
sarily arise  from  such  a  proposition  that  the  three 
plans  under  consideration,  as  well  as  numerous  others 
of  the  same  general  description,  varied  from  one  an- 
other. These  variations  were  of  great  significance 
when  it  was  sought  to  adopt  a  piece  of  practical  legisla- 
tion for  the  purpose  of  remedying  existing  conditions; 
but  they  were  not  fundamentally  important  from  the 
general  theoretical  standpoint. 

The  particulars  in  which  the  various  plans  differed 


FEDERAL  RESERVE   ORGANIZATION     425 

one  from  another  are  numerous,  but  the  principal 
points  upon  which  those  who  had  framed  these  plans 
concentrated  their  attention  may  be  enumerated  as 
follows : 

1.  Methods  of  providing;  capital  for  the  suggested 
central  organization. 

2.  Relationship  between  the  central  organization 
and  branches  of  the  same. 

3.  Details  of  the  relationship  between  the  institution 
and  its  branches,  on  the  one  hand,  and  existing  banks, 
on  the  other. 

4.  Relations  between  the  proposed  institution  and 
its  branches,  on  the  one  hand,  and  the  public,  on  the 
other. 

5.  Relations  between  existing  institutions,  on  the 
one  hand,  and  the  government,  on  the  other. 

6.  Methods  of  controlling  the  proposed  mechanism. 

7.  Details  of  the  lines  of  business  to  be  transacted 
by  the  proposed  institution. 

Although  the  Aldrich  bill  was  in  a  general  way  in 
line  with  what  had  been  often  urged  and  widely  talked 
about  both  in  Congress  and  out  of  it,  and  although  it 
could  have  been  amended  in  such  a  way  as  to  eliminate 
many  of  the  objectionable  ideas  which  had  been 
veneered  upon  the  fundamental  basis  of  banking  theory 
and  practice  which  constituted  its  substructure,  the 
measure  never  commended  itself  to  the  public.  As  a 
matter  of  fact,  it  never  received  consideration  at  the 
hands  of  a  committee  in  either  house  of  Congress,  and 
within  a  few  months  after  it  was  introduced  the  con- 
trol of  both  houses  had  largely  slipped  from  the  hands 
of  the  political  group  which  was  responsible  for  it. 
The  Democratic  party  had  succeeded  the  Republican 
in  full  charge  of  the  House  of  Representatives,  and  a 


426  BANKING  AND   BUSINESS 

combination  of  party  groups  had  practically  deprived 
the  conservative  Republicans  in  the  upper  chamber  of 
Congress  of  the  majority  control  which  they  had  long 
exercised  there.  Upon  the  Banking  and  Currency 
Committee  of  the  House  of  Representatives  fell  the 
duty  of  examining  the  great  mass  of  information 
already  collected  with  reference  to  currency  and  bank- 
ing, of  analyzing  the  data  at  hand,  of  simplifying  the 
results  thus  obtained,  and  of  selecting  those  which 
were  deemed  most  worthy  to  be  incorporated  into  a 
measure  for  the  reorganization  of  the  banking  and 
currency  system  of  the  nation. 

VII.  Legislative  History  of  the  Federal  Reserve 
Act. 

1 .  Features  of  the  Original  Bill. 

Upon  the  basis  of  careful  investigation,  conducted 
under  direction  and  supervision  of  that  committee, 
partly  at  pubhc  hearings  during  the  winter  of  1912-13, 
partly  by  private  investigations,  it  w^as  finally  deter- 
mined what  features  should  and  w^hat  points  should 
not  be  embodied  into  a  new  banking  measure.  The 
bill  thus  drafted  was  first  submitted  to  and  received 
the  approval  of  President  Woodrow  Wilson,  and  w^as 
thus,  when  introduced  in  the  House  of  Representatives 
on  June  18th,  an  administration  bill  in  the  sense  that  it 
had  received  the  approval  of  those  charged  with  ad- 
ministrative responsibiUty,  while  it  had  been  developed 
by  the  authorized  legislative  agencies  of  Congress. 
As  thus  drafted  for  presentation,  the  banking  biU 
covered  certain  main  points,  which  w^ere  subjected  to 
no  serious  change  and  which  were  there  succinctly  re- 
viewed in  a  report,  submitted  to  the  House  on  Sep- 
tember 9,  1913,  by  Chairman  Glass  on  behalf  of  the 
Banking  and  Currency  Committee,  as  follows: 


FEDERAL   RESERVE   ORGANIZATION     427 

After  looking  over  the  whole  ground,  and  after  examining  the 
various  suggestions  for  legislation,  some  of  which  have  just  been 
outlined,  the  Committee  on  Banking  and  Currency  is  firmly  of  the 
opinion  that  any  effective  legislation  on  banking  must  include  the 
following  fundamental  elements,  which  it  considers  indispensable 
in  any  measure  likelj'  to  prove  satisfactory  to  the  country: 

1.  Creation  of  a  joint  mechanism  for  the  extension  of  credit  to 
banks  which  possess  sound  assets  and  which  desire  to  licjuidate 
them  for  the  purpose  of  meeting  legitimate,  commercial,  agricul- 
tural, and  industrial  demands  on  the  part  of  their  chentele. 

2.  Ultimate  retirement  of  the  present  bond-secured  currency, 
with  suitable  provision  for  the  fulfilhnent  of  government  obliga- 
tions to  bondholders,  coupled  with  the  creation  of  a  satisfactorj' 
flexible  currency  to  take  its  place. 

3.  Provision  for  better  extension  of  American  banking  facilities 
in  foreign  countries  to  the  end  that  our  trade  abroad  may  be  en- 
larged and  that  American  business  men  in  foreign  countries  may 
obtain  the  accommodations  they  require  in  the  conduct  of  their 
operations. 

Beyond  these  cardinal  and  simple  propositions  the  committee 
has  not  deemed  it  wise  at  this  time  to  make  any  recommendations, 
save  that  in  a  few  particulars  it  has  suggested  the  amendment  of 
existing  provisions  in  the  Nat'onal  Bank  Act,  with  a  view  to 
strengthening  that  measure  at  points  where  experience  has  shown 
the  necessity  of  alteration. 

4.  In  order  to  meet  the  requirements  thus  sketched,  the  com- 
mittee proposes  a  plan  for  the  organization  of  reserve  or  rediscount 
institutions  to  which  it  assigns  the  name  "Federal  Reserve  banks." 
It  recommends  that  these  be  established  in  suitable  places  through- 
out the  country  to  the  number  of  twelve  as  a  beginning,  and  that 
they  be  a.ssigned  the  function  of  bankers'  banks.  Under  the 
committee's  plan  these  banks  would  be  organized  by  existing  banks, 
both  national  and  state,  as  stockholders.  It  believes  that  banking 
institutions  which  desire  to  be  knowii  by  the  name  "National" 
should  be  required,  and  can  well  afford,  to  take  upon  themselves 
the  responsibilities  involved  in  joint  or  federated  organization.  It 
recommends  that  these  bankers'  banks  shall  be  given  a  dofinit* 
capital,  to  he  subscribed  and  paid  by  their  constituent  member 
banks  which  hold  their  shares,  and  that  they  shall  do  business  only 
with  the  banks  aforesaid,  and  with  the  government.  Pubhc  funds, 
it  recommends,  shall  be  deposited  in  these  new  banks,  wiiich  shall 
thus  acciuire  an  essentially  public  character  and  shall  be  subject 
to  the  control  and  oversight  which  is  a  necessar>'  concomitant  of 


428  BANKING  AND   BUSINESS 

such  a  character.  In  order  that  these  banks  may  be  effectively 
inspected,  and  in  order  that  they  may  pursue  a  banking  poHcy 
which  shall  be  uniform  and  harmonious  for  the  country  as  a  whole, 
the  committee  proposes  a  general  board  of  management  intrusted 
with  the  power  to  overlook  and  direct  the  general  functions  of  the 
banks  referred  to.  To  this  it  assigns  the  title  of  "The  Federal 
Reserve  Board."  It  further  recommends  that  the  present  national 
banks  shall  have  their  bonds  now  held  as  security  for  circulation 
paid  at  the  end  of  twenty  years,  and  that  in  the  meantime  they 
may  turn  in  these  bonds  by  a  gradual  process,  receiving  in  exchange 
3-per-cent  bonds  without  the  circulation  privilege. 

In  lieu  of  the  notes  now  secured  by  national  bonds  and  issued 
by  national  banks,  and,  so  far  as  necessary  in  addition  to  them,  the 
committee  recommends  that  there  shall  be  an  issue  of  "Federal 
Reserve  Treasury  notes,"  to  be  the  obhgations  of  the  United 
States,  but  to  be  paid  out  solely  through  Federal  Reserve  banks 
upon  the  application  of  the  latter,  protected  by  commercial  paper; 
and  with  redemption  assured  tlu'ough  the  holding  of  a  reserve  of 
gold  amounting  to  33M  per  cent  of  the  notes  outstanding  at  any 
one  time.  In  order  to  meet  the  requirements  of  foreign  trade,  the 
conamittee  recommends  that  the  power  to  estabhsh  foreign  branch 
banks  shall  be  bestowed  upon  existing  national  banks  under  care- 
fully prescribed  conditions,  and  that  Federal  Reserve  banks  shall 
also  be  authorized  to  estabhsh  offices  abroad  for  the  conduct  of 
their  own  business  and  for  the  pm^pose  of  facihtating  the  fiscal 
operations  of  the  United  States  government.  Finally  and  lastly, 
the  committee  suggests  the  amendment  of  the  National  Bank 
Act  in  respect  to  two  or  three  essential  particulars,  the  chief  of 
which  are  bank  examinations,  the  present  conditions  under  wliich 
loans  are  made  to  farming  interests,  and  the  Uabihty  of  stockholders 
of  failed  banks.  It  beUeves  that  these  reconunendations,  if  carried 
out,  will  afford  the  basis  for  the  complete  reconstruction  and  the 
very  great  strengthening  and  improvement  of  the  present  banking 
and  credit  system  of  the  United  States.  The  chief  e\ils  of  which 
complaint  has  been  made  will  be  rectified,  while  others  wiU  at  least 
be  palliated  and  put  in  the  way  of  later  ehmination. 

The  Federal  Reserve  banks  suggested  by  the  com- 
mittee as  just  indicated  were  to  be  in  effect  co-operative 
institutions  carried  on  for  the  benefit  of  the  community 
and  of  the  banks  themselves  by  the  banks  acting  as 
stockholders  therein.    It  was  proposed  that  they  should 


FEDERAL   RESERVE   ORGANIZATION     429 

have  an  acti\'e  capital  equal  to  10  per  cent  of  the  capital 
of  existing  banks  which  might  take  stock  in  the  new 
enterprises.  This  would  result  in  a  capital  of  some- 
thing over  $100,000,000  for  the  Reserve  banks  taken 
together,  if  practically  all  existing,  banks  should  ent-er 
the  system.  It  was  supposed,  for  a  number  of  reasons, 
that  the  banks  would  so  enter  the  system.  More  will  be 
said  on  this  point  later  in  the  discussion.  How  many 
state  banks  would  apply  for  and  be  granted  admission 
to  the  new  system  as  stockholders  in  the  Reserve  banks 
could  not  be  confidently  predicted.  It  was,  however, 
thought  fair  to  assume  at  this  point  that  the  total 
capital  of  the  Keser\'e  banks  would  be  in  the  neighbor- 
hood of  S100,000,000.  The  bill  recommended  by  the 
committee  pro^'ide.i  for  the  transfer  of  the  present  funds 
of  the  government,  included  in  what  is  known  as  the 
general  fund,  to  tlie  new  Federal  Reser^'e  banks,  which 
were  thereafter  to  act  as  fiscal  agents  of  the  government. 
The  total  amount  of  funds  which  would  thus  be  trans- 
ferred could  not  then  be  predicted  with  absolute  accu- 
racy, but  the  released  balance  in  the  general  fund  of  the 
Treasury  was  not  far  from  $135,000,000.  Certain  other 
funds  then  held  in  the  department  would  in  the  course 
of  time  be  transferred  to  the  banks  in  this  same  way, 
and  that  would  result  in  placing,  according  to  the 
estimates  of  good  authorities,  an  ultimate  sum  of  from 
$200,000,000  to  $250,000,000  in  the  hands  of  the 
Re.ser\-e  banks.  If  the  former  amount  be  assumed  to 
be  correct,  it  was  seen  that  the  Reserve  banks  would 
start  shortly  after  their  organization  with  cash  resources 
of  at  least  $300,000,000.  As  will  presently  be  seen  in 
greater  detail,  it  was  proposed  to  give  to  the  Reserve 
banks  the  reserves  then  held  by  individual  banks  as 
reserve  holders  under  the  National  Banking  Act  for 
other  banks.  Confining  attention  to  the  national  sys- 
tem, it  was  probable  that  the  transfer  of  funds  thus  to 


430  BANKING  AND   BUSINESS 

be  made  by  the  end  of  a  year  from  the  date  at  which 
the  new  system  would  be  organized  would  be  in  the 
neighborhood  of  $350,000,000.  If  state  banks  entered 
the  system  and  conformed  to  the  same  reserve  require- 
ments, they  would  proportionately  increase  this  amount, 
but  for  the  sake  of  conservatism  the  discussion  was  at 
first  to  be  confified  to  the  national  banks.  From  figures 
which  were  developed  from  bank  returns,  it  seemed 
likely  that  at  least  $250,000,000  of  the  reserves  just 
referred  to  would  be  transferred  to  the  Reserve  banks 
in  cash;  and  if  this  were  done  the  total  amount  of 
funds  which  they  would  have  in  hand  would  be  at 
least  $550,000,000.  This  would  create  a  reservoir  of 
liquid  funds  far  surpassing  anything  of  similar  kind 
ever  available  in  this  country  theretofore.  It  would 
compare  favorably  with  the  resources  possessed  by 
government  banking  institutions  abroad. 

It  will  be  observed  that  in  what  has  just  been  said 
the  Reserve  banks  have  been  spoken  of  as  if  they 
were  a  unit.  The  committee,  however,  recommended 
that  they  should  be  individually  organized  and  in- 
dividually controlled,  each  holding  the  fluid  funds  of 
the  region  in  which  it  was  organized  and  each  ordinarily 
dependent  upon  no  other  part  of  the  country  for  as- 
sistance. The  only  factor  of  centralization  which  had 
been  provided  in  the  committee's  plan  was  found  in 
the  Federal  Reserve  Board,  which  was  to  be  a  strictly 
government  organization  created  for  the  purpose  of  in- 
specting existing  banking  institutions  and  of  regulating 
relationships  between  Federal  Reserve  banks  and  be- 
tween them  and  the  government  itself.  Careful  study 
of  the  elements  of  the  problem  had  convinced  the  com- 
mittee that  every  element  of  advantage  found  to  exist 
in  co-operative  or  central  banks  abroad  could  be  realized 
by  the  degree  of  co-operation  which  would  be  secured 
through  the  Reserve-bank  plan  recommended,  while 


FEDERAL   RESERVE   ORGANIZATION     431 

many  dangers  and  possibilities  of  undue  control  of  the 
resources  of  one  section  by  another  would  be  avoided. 
Local  control  of  banking,  local  application  of  re- 
sources to  necessities,  combined  with  federal  super- 
vision, and  limited  by  federal  authority  to  compel 
the  joint  application  of  bank  resources  to  the  relief  of 
dangerous  or  stringent  conditions  in  any  locality,  were 
the  characteristic  features  of  the  plan  as  thus  put  for- 
ward. The  limitation  of  business  which  was  proposed 
in  the  sections  governing  rediscounts,  and  the  mainte- 
nance of  all  operations  upon  a  footing  of  relatively 
short  time,  would  keep  the  assets  of  the  proposed  insti- 
tutions in  a  strictly  fluid  and  avai  able  condition,  and 
would  insure  the  presence  of  the  means  of  accommoda- 
tion when  banks  apply  for  loans  to  enable  them  to 
extend  to  their  clients  larger  degrees  of  assistance  in 
business.  It  was  proposed  that  the  goverimient  should 
retain  a  sufficient  power  over  the  Reserve  banks  to 
enable  it  to  exercise  a  directing  authority  when  neces- 
sary to  do  so,  but  that  it  should  in  no  way  attempt  to 
carry  on  through  its  own  mechanism  the  routine 
operations  of  banking,  which  required  detailed  knowl- 
edge of  local  and  individual  credit  and  which  determined 
the  actual  use  of  the  funds  of  the  community  in  any 
given  instance.  In  other  words,  the  Reserve-bank 
plan  retained  to  the  go\'ernment  power  over  the  exer- 
cise of  the  broader  banking  functions,  while  it  left  to 
individuals  and  privately  owned  institutions  the  actual 
directions  of  routine. 

2.  Congressional  Action  on  the  Bill. 

As  first  presented,  the  bill  was  taken  in  hand  by  the 
House  Committee  on  Banking  and  Currency,  which, 
however,  had  not  been  named  until  a  few  days  previous 
to  the  introduction  of  the  measure.  The  conunittee 
held  its  first  meeting  June  6th,  then  began  the  active 


432  BANKING  AND   BUSINESS 

work  of  considering  the  bill  on  July  7th,  and  continued 
regular  sessions  several  hours  each  day  until  the 
beginning  of  September.  The  bill  was  then  reported 
to  a  Democratic  caucus  and  after  a  period  of  detailed 
discussion  behind  closed  doors  was  ratified,  and  was 
thereupon  formally  reported,  on  September  9th,  to  the 
House  of  Representatives,  where  it  was  taken  under 
debate  on  September  10th  and  ultimately  forced  to  a 
passage  in  the  House  on  September  18th.  It  was  then 
sent  to  the  Upper  Chamber  and  was  taken  under 
advisement  in  the  Senate  Banking  Committee,  where 
extensive  hearings  were  promptly  begun,  and  were 
continued  until  October  25th.  Thereafter,  a  month 
of  consideration  in  committee  ensued,  and  subsequently 
three  days  of  caucus  consideration  in  the  Senate,  a 
final  report  to  the  Senate  as  such  being  rendered  on 
December  1st.  Debate  then  began  and  was  continued, 
first  in  the  intervals  of  business  already  scheduled, 
then  at  practically  continuous  sessions  until  December 
19th,  when  a  final  vote  was  secured  and  the  measure 
within  twenty-four  hours  sent  to  conference,  from 
which  it  emerged  on  December  22d,  receiving  the 
President's  signature  on  the  following  day. 

When  reported  by  the  Senate  Banking  Committee, 
after  its  own  consideration  and  that  of  the  caucus,  the 
banking  bill  contained  no  important  changes  in  theory, 
as  compared  with  the  House  draft,  save  only  in  the 
section  which  related  to  the  method  of  retiring  existing 
national-bank  circulation  and  of  providing  for  the 
refunding  of  United  States  2-per-cent  bonds.  The 
bill,  however,  differed  essentially  from  the  House 
measure  in  many  details,  some  of  them  of  great  im- 
portance, others  of  minor  significance.  The  frame- 
work of  the  bill  had  been  changed  in  no  fundamental 
particular,  but  remained  as  it  had  been  originally  con- 


FEDERAL  RESERVE   ORGANIZATION     433 

btructed.  The  detailed  changes,  taken  in  the  aggre- 
gate, would,  however,  ha\e  altered  in  a  considerable 
degree  its  scope  and  effect.  A  sketch  of  these  changes 
must,  therefore,  be  presented  at  this  point. 

As  reported  by  the  Senate  committee,  the  bill, 
instead  of  providing  for  a  series  of  Reserve  banks  not 
less  than  twelve  in  number,  whose  stock  was  to  be 
owned  exclusively  by  existing  national  and  state  banks, 
provided  for  not  less  than  eight  nor  more  than  twelve 
of  such  banks,  and  permitted  the  stock,  if  not  taken 
up  by  existing  banks  through  subscription,  to  be  sold 
to  the  public,  or,  if  not  subscribed  for  by  the  pubhc, 
to  be  allotted  to  the  United  States  government.  It 
slightly  altered  the  method  of  voting  for  directors 
of  Reserve  banks  from  the  plan  prescribed  in  the 
House  bill.  It  relieved  the  national  banks  entering 
the  system  of  the  necessity  of  rechartering.  The 
Federal  Reserve  Board  was  somewhat  changed  in  com- 
position through  the  elimination  of  the  ex-officio  mem- 
ber dra\Mi  from  the  administration,  and  was  given 
broader  and  less  restricted  powers  than  had  been  con- 
ferred by  the  House  bill,  although  none  of  a  new  or 
fundamental  nature  was  added.  The  Senate  com- 
mittee, moreover,  instead  of  making  the  deposit  of 
public  funds  in  Reserve  banks  mandatory,  left  it  to  the 
discretion  of  the  Secretary  of  the  Treasury  to  deposit 
such  funds  or  not,  as  he  might  see  fit,  although  the 
tenor  of  the  provision  on  this  subject  was  such  as  to 
indicate  that  the  declared  pohcy  of  the  United  States 
would  in  the  future  be  that  of  making  the  deposits  with 
the  Reserve  banks  rather  than  with  national  banks,  as 
in  the  past. 

As  a  method  of  retiring  United  States  bonds  and 
national-bank  circulation,  the  Senate  bill  provided 
that  these  securities  might  be  annually  assigned  to 
Federal  Reserve  banks  in  a  sum  not  to  exceed  $25,000,- 


434  BANKING  AND   BUSINESS 

000,  the  banks  to  be  required  to  purchase  the  bonds 
at  par  from  their  existing  owners  and  to  issue  upon 
them,  as  security,  notes  exactly  similar  to  existing 
national-bank  notes  and  subject  to  the  same  require- 
ments, limitations,  and  obligations. 

In  dealing  with  the  reserve  question,  it  was  provided 
that  Federal  Reserve  banks  should  maintain  35  to  40 
per  cent,  instead  of  33J^  per  cent,  as  in  the  House  bill, 
and  that  national  banks  should  maintain  in  central 
reserve  cities  18  per  cent,  in  reserve  cities  15  per  cent, 
and  in  the  country  12  per  cent,  of  demand  deposits, 
with  5  per  cent  against  time  deposits,  both  the  propor- 
tion to  be  kept  in  the  Reserve  banks  and  the  rate  of 
transfer  being  altered,  as  compared  with  the  House 
bill,  in  such  a  way  as  to  make  the  process  of  transfer 
easier  for  the  contributing  banks.  By  way  of  still 
further  lightening  the  burden  which,  it  was  supposed, 
would  be  imposed  upon  the  banks  in  this  process  of 
transfer,  it  was  provided  that  one-half  of  the  credits 
to  be  established  with  the  Reserve  banks  created  under 
the  bill  might  be  paper  ehgible  for  rediscount,while  the 
notes  issued  by  the  Reserve  banks  were  also  allowed  to 
be  counted  in  the  reserves  of  these  member  banks. 
The  Senate  bill,  moreover,  extended  the  provisions  of 
the  so-called  Aldrich-Vreeland  law  of  1908,  and  inserted 
in  the  measure  a  provision  authorizing  the  Secretary 
of  the  Treasury  to  sell  bonds  for  gold,  should  such  a 
measure  be  necessary  at  any  time  to  maintain  the  re- 
deemableness  of  Federal  Reserve  notes.  Lastly,  the 
Senate  bill  largely  altered  the  provision  which  had  been 
made  in  the  House  for  the  collection  of  checks  and 
drafts  at  par  throughout  the  country.  While  under 
debate  in  the  Senate,  the  bill  underwent  some  further 
alterations,  none  of  which,  however,  materially  changed 
its  more  important  aspects,  as  already  described.  Such 
clauses   as   were   inserted   were   intended   mainly   to 


FEDERAL  RESERVE   ORGANIZATION     435 

clarify  the  language  or  to  add  further  safeguards  which 
had  been  found  or  thought  to  be  necessary  here  and 
there  as  the  work  proceeded. 

Little  needs  to  be  said  of  the  debate  in  the  Senate. 
It  is  doubtful  whether  any  important  provision  was 
altered  on  the  floor  as  the  result  of  discussion,  although 
a  few  points  at  which  the  measure  was  weak  were 
subsequently  rectified,  probably  as  a  result  of  the 
repeated  attacks  to  which  they  had  been  subjected 
during  the  weeks  before  the  measure  was  finally 
adopted.  As  the  bill  ultimately  passed  the  Senate  it 
differed  from  the  plan  of  the  House  in  no  respect  that 
was  of  theoretical  importance.  It  retained  the  pro- 
vision for  sales  of  stock  to  private  holders  and  for  the 
voting  of  the  stock  by  trustees  representing  these 
holders,  as  well  as  for  the  purchase  of  stock  by  the 
United  States  itself,  in  case  of  necessity  for  so  doing. 
It,  moreover,  introduced  a  change  in  the  method  of 
distributing  the  earnings  of  Federal  Reserve  banks 
whereby  a  portion  of  those  earnings  was  to  be  emploj-ed 
for  establishing  a  fund  for  guaranteeing  the  deposits 
of  member  banks  which  had  taken  stock  in  the  Federal 
Reserve  banks  of  their  district.  It  altered  the  number 
of  banks  by  cutting  it  to  no  less  than  eight  and  not 
more  than  tvv'elve,  in  place  of  the  "at  least  twelve"  of 
the  House  bill.  While  many  minor  changes  and  altera- 
tions of  wording  were  made  throughout,  they  did  not 
alter  the  essential  structure  of  the  plan,  but  in  some 
cases  carried  it  farther  than  the  framers  of  the  House 
measure  had  been  able  to  do,  embod^dng  ideas  that 
had  been  urged  by  them  while  the  measure  was  under 
discussion,  but  for  which  they  had  not  succeeded  in 
obtaining  indorsement.  Perhaps  the  most  injurious 
features  which  were  added  during  the  Senate  stage  of 
the  measure  were  the  provision  cutting  reserves  of 
member  banks,  and  that  permitting  the  introduction 


436  BANKING  AND  BUSINESS 

of  bank  notes  into  reserves  as  a  constituent  element 
therein. 

3.  Contents  of  the  Final  Bill. 

The  substance  of  the  work  done  in  conference  com- 
mittee may  be  summarized  somewhat  further  in  order 
to  bring  out  the  points  that  had  been  accepted  as  in- 
novations upon  the  House  bill  and  those  that  had  been 
rejected  because  the  changes  proposed  in  them  were 
not  deemed  wise.  Turning  first  to  the  alterations  in 
the  House  bill  that  secured  acceptance,  the  principal 
features  may  be  enumerated  as  follows: 

1.  Introduction  of  provision  for  sale  of  stock  in 
Federal  Reserve  banks  to  the  public  in  the  event  that 
not  enough  banks  subscribe  for  the  stock  to  furnish  an 
adequate  capital  in  any  given  district. 

2.  Provision  for  alternative  voting  in  the  choice  of 
directors  of  Federal  Reserve  banks  so  as  to  insure 
prompt  election, 

3.  Reduction  of  number  of  Federal  Reserve  banks  to 
not  more  than  twelve,  as  against  the  ''at  least  twelve" 
of  the  House  bill. 

4.  Elimination  of  requirement  that  all  national  banks 
recharter. 

5.  Broadening  of  powers  of  Federal  Reserve  Board 
and  modification  of  language  relating  to  rediscounts 
between  Federal  Reserve  banks,  so  as  to  render  such 
rediscounts  easier  than  was  intended  by  the  House  bill. 

6.  Provision  that  the  Secretary  of  the  Treasury 
might,  not  must,  deposit  pubUc  funds  in  Reserve  banks. 

7.  Reduction  of  reserve  requirements  placed  upon 
member  banks  under  House  bill. 

On  the  other  hand,  the  following  important  points 
were  yielded  by  the  Senate  in  the  conference : 


FEDERAL  RESERVE   ORGANIZATION     437 

1.  Omission  of  provision  that  holders  of  stock  sold 
to  private  individuals  (if  any)  should  have  voting 
power  in  directorates  of  Federal  Reserve  banks  and 
elsewhere. 

2.  EUinination  of  guaranty  of  bank  deposits  by  use 
of  surplus  earnings. 

3.  Elimination  of  provision  that  Federal  Reserve 
Bank  notes  might  be  counted  in  reserves  of  stock- 
holding banks. 

4.  Restoration  of  provision  that  many  classes  of 
checks  should  be  collected  at  par  throughout  the 
countr}^,  and  that  where  such  par  collection  was  not 
enforced  the  charge  for  making  collection  should  be 
fixed  by  the  Federal  Reserve  Board. 

5.  Eliminrition  of  domestic  acceptances,  thereby 
excluding  them  for  use  by  stockholding  banks  and 
from  rediscount  by  Federal  Reserve  banks. 

6.  IModification  of  reserve  requirements  as  formu- 
lated by  the  Senate  so  as  to  require  actual  cash  reserves 
in  the  vaults  of  country  banks  (the  Senate  having 
entirely  dispensed  with  such  reserves  after  twenty-four 
months  after  date  of  the  passage  of  the  Act)  and 
general  stiffening  of  reserve  requirements  made  by  the 
Senate,  although  the  final  language  still  constituted  a 
reduction  below  the  House  provision. 

7.  Reduction  of  period  of  maturity  for  which  dis- 
countable paper  might  run. 

While  many  other  points  of  modification  and  con- 
cession on  either  side  might,  of  course,  be  enumerated, 
it  is  beheved  that  the  foregoing  presentation  is  repre- 
sentative, and  shows  sufficiently  well  the  nature  of  the 
conference  work  and  the  character  of  the  points  con- 
cetled  on  either  side.  Assuming  that  such  a  fair  or 
representative  selection  has  been  made,  it  is  evident 
that  the  work  of  the  conference  resulted  in  the  estab- 


438  BANKING  AND  BUSINESS 

lishment  of  the  House  contentions  at  nearly  every 
essential  point,  the  exceptions  to  such  a  remark  being 
found  in  two  main  particulars :  (1)  the  reduction  in  the 
number  of  Reserve  banks  and  their  Umitation  to  not 
more  than  twelve  at  any  time,  and  (2)  the  provision 
that  public  deposits  might  or  might  not  be  made  in 
the  Reserve  banks,  at  the  discretion  of  the  Secretary 
of  the  Treasury.  While  other  points  were  significant 
and  important  in  their  way,  it  can  certainly  be  fairly 
concluded  that  on  those  matters  involving  important 
issues  of  theory  the  House  virtually  held  its  own  in 
most  respects.  In  fact,  it  is  an  accurate  generalization 
that  the  final  bill  as  completed  in  conference  conmiittee, 
and  as  passed  by  both  Houses,  was  a  closer  approach 
to  the  original  House  draft  of  the  measure  than  any- 
thing that  had  intervened  during  the  time  the  bill 
was  going  through  the  various  permutations  to  which 
it  was  subjected  in  its  slow  progress  from  one  stage 
to  another  of  the  legislative  process. 

At  one  other  point  there  was  marked  and  vital 
departure  from  the  original  House  measure — the  pro- 
vision with  reference  to  the  refunding  of  United 
States  2-per-cent  bonds  and  the  treatment  of  the  cur- 
rency based  upon  such  bonds.  On  this  subject  the 
final  action  of  the  conference  was  nearly  equivalent 
to  the  acceptance  of  a  plan  formulated  by  the  adminis- 
tration and  designed  to  take  the  place  of  all  of  the 
various  other  schemes  that  had  been  recommended 
from  different  sources  in  either  House. 

To  the  scientific  student  of  banking  it  need  hardly 
be  said  that  the  striking  aspects  of  the  legislation  were 
these  three:  (1)  the  creation  of  a  general  discount 
market  for  comimercial  paper;  (2)  the  systematic  pool- 
ing of  reserves  of  existing  banks;  and  (3)  the  pro- 
vision of  an  elastic  currency.  In  the  multitude  of 
details  provided  by  the  legislation,  and  in  the  various 


FEDERAL  RESERVE   ORGANIZATION     439 

adjustments  rendered  necessary  b}^  it  with  respect  to 
government  deposits,  bank  reserves,  examinations,  and 
other  more  or  less  important  matters,  it  is  noticeable 
throughout  that  everything  done  had  been  for  the 
purpose  of  promoting  the  objects  already  enumerated, 
and  of  insuring  the  transformation  of  American  bank- 
ing i'rom  its  older  basis  of  organization  to  its  new  pro- 
posed type  of  effort. 


CHAPTER   XXVI 

OPERATION   OF  THE  FEDERAL  RESERVE  SYSTEM » 

I,  The  Federal  Reserve  Board. 

Governmental  supervision  of  banking  is  everyw' here 
to-day  accepted  as  a  public  necessity.  Under  the  old 
National  Bank  Act  it  was  furnished  by  the  Comptroller 
of  the  Currency.  Under  the  Federal  Reserve  Act  a 
new  mechanism  for  it  is  supphed  by  the  Federal  Reserv^e 
Board. 

The  Federal  Reserve  Board  is  the  central  controlUng 
and  directing  mechanism  of  the  Federal  Reserve  system 
and,  therefore,  of  the  banking  system  of  the  United 
States.  Under  the  terms  of  the  Act  it  is  appointed  by 
the  President,  by  and  ^dth  the  ad\dce  and  consent  of 
the  Senate,  subject  to  the  following  limitations: 

1.  No  two  members  of  the  board  can  be  chosen  from 
the  same  district. 

2.  Each  member  must  have  been  a  bona-fide  resident 
of  the  district  from  which  he  is  appointed  for  two  years 
preceding  his  appointment. 

3.  Two  members  of  the  board  must  be  men  of  prac- 
tical experience  in  banking  and  finance. 

Subject  to  these  limitations,  the  President,  M-ith  the 
confirmation  of  the  Senate,  appoints  five  persons  of  his 
own  selection.  These,  together  with  the  Comptroller 
of  the  Currency  and  the  Secretary  of  the  Treasury, 

^The  first  twelve  pages  of  this  chapter  are  reprinted  by  permission 
of  the  publishers  (The  La  Salle  Extension  University)  from  American 
Banking,  by  H.  P.  WilUs. 


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FEDERAL   RESERVE   OPERATION    441 

make  up  the  Federal  Reserve  Board.  The  Secretary  of 
the  Treasury  is  ex-officio  chairman  of  the  board,  but 
the  board  has  ahvays  a  chief  executive  officer,  known  as 
the  governor,  and  a  second  executive,  similarly  named, 
and  known  as  the  vice-governor.  The  board  has  power 
to  adopt  its  own  by-laws,  rules  of  operation,  and  the 
like,  and  to  select  its  own  place  of  meeting. 

Its  functions  are  lengthy  and  detailed,  but  they  may 
be  briefly  summarized  under  the  following  main  heads : 

1.  To  select  government  directors  in  Federal  Reserve 
banks  and  to  approve  or  disapprove  the  salaries  of 
officers  of  the  banks. 

2.  To  establish  rules  and  regulations  for  the  manage- 
ment of  business  in  the  several  districts. 

3.  To  review  the  rate  of  discount  at  Federal  Reserve 
banks  and  to  originate  the  rate  of  rediscount  between 
Federal  Reserve  banks. 

4.  To  regulate  the  reserve  holdings  of  the  several 
banks  and  to  impose  penalties  or  fines  upon  those 
banks  that  permit  their  reserves  to  fall  below  the 
specified  limit. 

The  permanent  and  regular  duties  of  the  Federal 
Reserve  Board  outlined  above  may  be  considered  under 
three  general  divisions: 

(1)  Administrative. 

(2)  Constructive. 

(3)  Educative. 

1.  Administrative  Duties. 

Administrative  functions  are  essentially  of  two  kinds: 
(a)  The  regular  and  recurring  duties  necessary  to  the 
operation  of  the  system,  and  (b)  the  sporadic  or  occa- 
sional duties  which  grow  out  of  the  operation  of  the 
Act,  but  which  do  not  occur  at  any  definite  time  or 
times. 


442  BANKING  AND   BUSINESS 

Of  the  regular  and  stated  duties  of  administration, 
probably  the  most  conspicuous  is  that  of  regularly 
approving  discount  rates  when  they  are  submitted  by 
the  several  banks.  To  do  this  work  intelhgently  involves 
careful  study  and  consideration  of  the  general  business 
conditions  throughout  the  nation,  of  the  situation  in 
each  of  the  reserve  districts  themselves,  and  of  the 
broad  general  outlook  for  the  future.  An  incidental 
consideration  is  necessarily  that  of  the  earnings  of 
Federal  Reserve  banks,  and  the  degree  in  which  it  is 
necessary  or  desirable  to  enlarge  those  earnings  through 
the  taking  on  of  more  business. 

Another  administrative  function  practically  continu- 
ous in  its  operation  is  that  of  granting  to  banks  power 
to  enlarge  their  acceptances  of  paper  up  to  100  per  cent 
of  their  capital  and  surplus,  and  of  extending  to  them 
the  right  to  exercise  the  functions  of  trustee,  executor, 
administrator,  and  the  like.  Under  the  terms  of  the 
Federal  Reserve  Act  these  powers  cannot  be  conveyed 
except  by  special  permit,  and  any  member  bank  which 
desires  to  make  use  of  them  must,  therefore,  obtain  the 
consent  of  the  board.  Under  the  system  which  has  been 
laid  down  by  the  board  this  involves  an  appUcation 
first  of  all  to  a  local  Federal  Reserve  bank,  and  when 
such  an  apphcation  has  been  approved  the  board  is  in 
position  to  take  action,  either  confirming  or  disapprov- 
ing the  findings  of  the  Federal  Reserve  bank  which 
had  passed  upon  it. 

The  law  requires  also  that  each  Federal  Reserve  bank 
shall  submit  to  the  Federal  Reserve  Board  statements 
of  compensation  paid  to  officers  and  directors,  that  they 
may  be  approved  by  the  board.  This  naturally  imphes 
a  study  of  proper  rates  of  compensation,  and  the  taking 
of  action  designed  to  fix  such  rates  when  occasion  de- 
mands. Once  estabhshed,  the  salary  Usts  of  the  Federal 
Reserve  banks  are  not  likely  to  show  extensive  changes, 


FEDERAL  RESERVE   OPERATION    443 

but  such  alterations  as  there  are  will  recur  and  require 
attention  from  time  to  time. 

Other  administrative  duties  must  likewise  be  per- 
formed, among  them  the  passing  upon  and  approval  of 
applications  for  and  surrender  of  capital  stock  in  Fed- 
eral Reserve  banks,  the  holdings  of  the  member  banks 
varying  according  as  their  own  capital  and  surpluses 
increase  and  decrease.  These,  however,  are  for  the 
most  part  technical,  and  no  further  enumeration  is 
necessary. 

2.  Constructive  Duties. 

The  constructive  duties  of  the  board  prescribed  by 
law  are  seen  to  best  advantage  in  the  provision  which 
calls  for  the  development  and  application  of  regulations 
designed  to  control  methods  of  business.  Since  the 
board  was  organized  it  has  issued  regulations  defining 
commercial  paper  ehgible  for  discount,  regulations  re- 
lating to  the  definition  of  savings  accounts,  rules  for 
the  issue  and  retirement  of  capital  stock,  rules  for  the 
purchase  of  warrants  and  bankers'  acceptances  in  the 
open  market,  and  a  variety  of  others. 

These  regulations  govern  the  practices  of  the  Federal 
Reserve  banks,  and  have  substantially  the  force  of  law, 
inasmuch  as  the  Federal  Reserve  Act  itself  calls  for  the 
exercise  of  these  functions  subject  to  the  rules  made  by 
the  board.  Inasmuch  as  the  character  of  the  rules  and 
regulations  thus  made  may  gradually  alter  the  scope 
and  methods  of  business  done  by  the  banks,  it  is  clear 
that  the  work  of  the  board  in  this  regard  is  in  the  high- 
est degree  constructive  in  its  nature.  At  times  it  is 
almost  equal  to  the  extensive  limitation  or  modification 
of  the  pro\4sions  of  the  law  itself. 

It  is  difficult  to  say  how  far,  when  the  system  is  fully 
perfected,  it  will  be  necessary  for  the  board  to  alter 
such  regulations.    It  may  be  expected  that  ultimately 


444  BANKING  AND   BUSINESS 

the  regulations  of  the  board  will  be  changed  but  Uttle, 
and  that  any  modifications  will  be  the  outcome  of 
observation  and  experience  of  banking  and  business 
conditions  throughout  the  nation.  By  changes  in  the 
discount  rate  the  volume  of  business  will  be  controlled; 
but  the  methods  of  business  at  the  banks  which  are 
dependent  upon  the  regulations  aforesaid  will  not  be 
greatly  altered.  At  present  the  Federal  Reserve  sys- 
tem is  still  in  process  of  development,  and  its  business 
practices  are  being  worked  out.  This  has  necessitated 
more  or  less  frequent  changes  in  regulations,  but  such 
changes,  as  already  indicated,  will  diminish  in  number 
as  time  goes  on. 

The  Act  has  also  placed  in  the  hands  of  the  Federal 
Reserve  Board  the  power  of  changing  and  readjusting 
the  reserve  districts,  subject  to  the  broad  general  re- 
quirements that  there  should  not  be  less  than  eight  or 
more  than  twelve.  How  extensive  such  readjustments 
of  the  districts  will  be,  experience  must  show;  and  when 
the  time  comes  to  make  them,  an  important  construc- 
tive function  of  the  board  will  be  that  of  determining 
when  and  how  they  shall  be  introduced.  Already  the 
board  has  granted  a  few  petitions  for  readjustment  of 
boundary  lines  between  districts. 

Of  the  same  general  character  is  the  provision  of  the 
Act  which  calls  for  the  estabhshment  of  branches,  and 
which  practically  invests  the  board  with  the  authority 
to  oversee  the  estabhshment  of  such  branches  of  Federal 
Reserve  banks.  The  operation  of  the  law  in  this  par- 
ticular intrusts  to  the  board  one  of  its  most  important 
duties  of  a  constructive  nature. 

S.  Educative  Functions. 

Among  the  implied  or  educative  duties  of  the  board 
is  undoubtedly  that  of  bringing  about  general  and  har- 
monious action  among  the  several  districts  and  of  weld- 


FEDERAL   RESERVE   OPERATION    445 

ing  the  different  parts  into  a  consistent,  unit-ed  whole. 
In  order  to  do  its  work  well  the  board  must  necessarily 
be  in  close  touch  with  the  several  districts  and  know 
what  is  going  on  in  them,  and,  with  this  purpose  in 
view,  direct  communication  with  the  different  districts 
has  been  intrusted  to  the  several  members  of  the  board 
in  order  that  they  may  keep  themselves  and  their  col- 
leagues advised  of  any  developments  in  these  districts 
which  call  for  special  attention. 

An  annual  report  to  Congress  was  required  by  law 
and  must  be  formulated  by  the  board.  It  was  also 
intrusted  with  the  duty  of  keeping  the  country  advised 
of  the  condition  of  the  system.  It  has  undertaken  to 
carry  out  this  duty  in  part  by  the  establishment  of  a 
publication  known  as  the  Federal  Reserve  Bulletin,  in 
which  are  collected  notices  and  statements  about  the 
work  undertaken  and  the  results  accomplished  in  the 
operation  of  the  system.  Much  more  might  be  said  of 
the  detailed  work  of  the  board  in  the  task  of  educating 
the  public  to  a  knowledge  of  its  operations  and  of 
standardizing  bankng  practices,  but  the  statements 
already  made  practically  cover  the  ground  in  its  most 
essential  aspects. 

II.  Organization  of  the  Board. 

The  Federal  Reserve  Act  imposes  practically  no 
limitations  upon  the  methods  by  which  the  board  per- 
forms its  o\vn  work.  In  accordance  with  the  provision 
of  the  law  which  authorizes  the  Secretary  of  the  Treas- 
ury to  provide  quarters  for  the  board  in  his  department, 
the  main  offices  at  Washington  have  been  located  in  the 
Treasury  Building,  ^\^lile  there  is  no  rigid  practice,  it 
has  been  customary  to  hold  meetings  from  three  to 
five  times  a  week,  usually  each  day,  although  two 
meetings  a  day  have  not  been  uncommon. 


446  BANKING  AND   BUSINESS 

A  set  of  by-laws  defining  the  organization  of  the 
board  was  early  adopted,  and  these  provide  for  an 
executive  committee  whose  function  it  is  to  transact  all 
necessary  business  not  involving  any  new  plans  or 
policy.  Other  committees  may  meet  occasionally  as 
convenience  dictates.  Sessions  of  the  board  are  held  in 
private,  and  thus  far  no  public  sessions,  with  the  excep- 
tion of  the  hearings  on  appeals  from  decisions  of  the 
Reserve  Bank  Organization  Committee,  have  been 
appointed. 

When  a  decision  has  been  arrived  at  with  reference 
to  a  proposed  change  in  the  discount  rate,  or  the  adop- 
tion of  any  new  pohcy  or  method  of  business,  the 
Federal  Reserve  agents  are  at  once  advised  by  telegraph 
or  letter,  and  then  the  decision  is  communicated  to  the 
various  Federal  Reserve  banks.  The  Federal  Reserve 
agent  is  regarded  by  the  board  as  its  representative  on 
the  ground,  and,  as  such,  the  official  medium  of  com- 
munication between  it  and  the  bank  to  which  he  is 
accredited;  although  the  board  may,  and  frequently 
does,  hold  direct  communication  with  the  governor  of 
the  Federal  Reserve  bank  as  being  the  active  operating 
officer. 

The  Comptroller  of  the  Currency  is  a  member  of  the 
Federal  Reserve  Board.  The  Federal  Reserve  Act  did 
not  change  his  pre\'ious  function  as  chief  of  the  national 
banking  system,  or  his  responsibihty  to  the  Secretary 
of  the  Treasury  and  to  Congress.  These  relationships, 
therefore,  continue,  and  his  presence  on  the  board 
simply  serves  to  establish  a  connecting  link  between  the 
supervision  of  the  national  banking  system  as  such,  and 
the  general  supervision  of  the  Federal  Reserve  system, 
including  Federal  Reserve  banks  and  such  non-national 
banks  as  may  have  become  members. 

In  the  same  way  the  Secretary  of  the  Treasury's 
membership  in  the  board  in  no  way  alters  his  other  re- 


FEDERAL  RESERVE  OPERATION    447 

lationships  or  duties.  The  fact  that  he  presides  over 
the  board  enables  him  to  communicate  to  it  necessary 
information  with  reference  to  the  pohcies  of  the  Treas- 
ury Department  on  financial  and  banking  questions, 
and  to  receive  from  it  advice  and  information  concern- 
ing the  work  of  the  Reserve  system. 

Under  the  Federal  Reserve  Act  the  placing  of  public 
deposits  in  the  Reserv^e  banks  is  left  entirely  in  the  hands 
of  the  Secretary  of  the  Treasury.  The  membership  of 
the  Secretary  of  the  Treasury  in  the  Federal  Reserve 
Board  should,  under  these  conditions,  be  much  more 
than  merely  formal,  and  includes  much  more  than  the 
mere  rendering  of  advice  and  suggestions.  It  is  of 
necessity  a  practical  working  participation  on  the  part 
of  the  Secretary  of  the  Treasury  in  the  affairs  of  the 
board,  and,  conversely,  a  participation  on  the  part  of 
the  board  as  a  conservator  of  the  banking  resources 
of  the  country  in  the  management  of  one  set  of  the 
activities  of  the  Treasury  Department. 

In  organizing  its  staff  at  Washington  for  the  perform- 
ance of  the  duties  already  enumerated  and  others  inci- 
dental to  them,  the  Federal  Reserve  Board  found  it 
desirable  to  recognize  several  distinct  divisions.  The 
task  of  examining  member  banks  (not  national)  and  of 
making  periodic  examinations  of  Federal  Reserve  banks 
has  been  committed  to  a  distinct  bureau  or  division 
known  as  the  Bureau  of  Audit  and  Examination,  headed 
by  a  chief  under  whom  is  organized  a  small  corps  of 
examiners  and  assistant  examiners.  The  task  of  examin- 
ing the  twelve  Federal  Reserve  banks  would  not  in 
itself  be  a  heavy  one,  but,  as  state  banks  ent-er  the 
system,  the  duty  of  ascertaining  whether  they  are  in 
suitable  condition  for  admission,  and  of  making  sure 
that  they  continue  to  be  so,  involves  a  considerable 
amount  of  labor. 

Another  of  the  main  divisions  into  which  the  board's 


448  BANKING  AND   BUSINESS 

work  is  divided  was  that  of  reports  and  statistics. 
When  the  Federal  Reserve  Act  was  drawn,  provision 
was  made  for  a  weekly  report  of  the  condition  of  all 
Federal  Reserve  banks  and  of  each  bank,  showing  the 
main  items  in  their  accounts.  This  is  prepared  in  the 
Division  of  Reports  and  Statistics  from  data  which  are 
weekly  telegraphed  to  the  board,  and  are  combined  to 
make  up  the  final  statements.  Provision  was  also  made 
when  the  Federal  Reserve  banks  were  organized  for 
regular  reports  by  the  several  banks  of  paper  purchased, 
with  name  of  purchaser,  maturity,  rate,  etc.  Complete 
lists  showing  all  these  items  of  information,  and  giving 
data  as  to  the  daily  condition  of  the  several  banks,  are 
daily  forwarded  to  Washington  by  each  one  of  the 
institutions.  It  was  the  duty  of  the  Division  of  Reports 
and  Statistics  to  combine  and  analyze  them  and  to 
prepare  the  result  of  the  study  in  such  form  for  examina- 
tion by  members  of  the  board  as  will  aid  them  in  forming 
conclusions  regarding  the  business  of  member  banks, 
as  indicating  necessary  changes  in  rates  of  discount,  and 
as  otherwise  determining  the  policy  to  be  pursued  in 
the  general  conduct  of  the  banking  system.  A  later 
modification  of  this  part  of  the  board's  work  was  made 
by  the  appointment  of  a  statistician  in  general  charge 
of  the  statistical  work  of  the  organization,  while  the 
routine  work  of  compiling  reports  was  left  to  the  Divi- 
sion of  Accounts  under  an  independent  head.  In  1918 
a  Division  of  Analysis  and  Research  was  organized.  To 
it  was  given  the  general  scientific  work  of  the  board 
and  the  supervision  of  the  monthly  Bulletin  and  other 
scientific  publications. 

In  the  Federal  Reserve  Act  it  was  specified  that  each 
Federal  Reserve  bank  might  act  as  a  clearing  house 
for  its  members,  but  that  the  Federal  Reserve  Board 
might  act  as  a  clearing  house  for  the  Federal  Reserve 
banks,  or  might  designate  one  of  the  Federal  ReserAc 


ii^-i 


FEDERAL  RESERVE   OPERATION    440 

banks  thus  to  act.  In  pursuance  of  this  authority,  the 
board  has  estabhshed  a  Division  of  Clearing  in  Washing- 
ton for  the  purpose  of  settUng  balances  between  Federal 
Reserve  banks  without  the  actual  shipment  of  coin. 
This  division  is  in  charge  of  a  fund  of  about  $426,000,- 
000  in  gold,  and  conducts  a  set  of  books  on  which  are 
recorded  from  day  to  day  credits  and  debits  between 
Federal  Reserve  banks  arising  out  of  their  operations 
during  the  day.  As  given  banks  are  credited  or 
debited  on  these  books,  the  amount  of  their  ownership 
in  the  gold  fund  changes. 

III.  Supervision  of  Reserve  Banks. 

Federal  Reserve  banks  which  are  under  special  obli- 
gations and  duties  are  not  only  closely  supervised  by, 
but  in  fact  operated  under,  close  government  super- 
vision. Two  features  deserve  to  be  specially  noted  in 
this  connection: 

1.  Owing  to  its  close  relation  with  the  government, 
each  Federal  Reserve  bank  has  a  special  officer  repre- 
senting the  government,  who  is  chairman  of  its  board 
of  directors  and  who  is  designated  as  **  Federal  Reserve 
agent." 

2.  Every  Federal  Reserve  bank  confines  its  discount 
business  to  other  banks,  a  fact  which  at  once  alters  the 
type  of  organization  of  the  institution  in  some  important 
particulars. 

IV.  Board  of  Directors. 

The  fundamental  control  of  the  Federal  Reserve 
bank  is  in  the  hands  of  the  board  of  directors,  consisting 
of  nine  members.  This  board  of  directors  consists  of 
three  classes,  each  containing  three  membei-s  and  each 


450  BANKING  AND  BUSINESS 

class  being  designated  by  a  letter,  as  A,  B,  and  C.  Class 
C  directors  are  nominated  by  the  Federal  Reserve 
Board  and  represent  the  government.  Class  B  direc- 
tors are  business  men  not  engaged  in  banking  who  are 
presumed  to  represent  in  a  general  way  the  industrial, 
commercial,  and  agricultural  interests  of  the  district  in 
which  the  bank  is  situated.  Class  A  directors  are 
directly  representative  of  the  banks. 

Both  Class  A  and  Class  B  directors  are  chosen  by  the 
banks,  and  for  the  purpose  of  this  selection  the  banks 
in  each  district  are  divided  into  three  groups.  Group 
one  chooses  one  Class  A  and  one  Class  B  director, 
group  two  the  same  number,  and  group  three  the  same. 
In  group  one,  the  voters  or  electors  are  the  banks  of 
large  capitalization;  in  group  two  those  of  medium 
capitalization;  and  in  group  three  the  small  banks. 
The  banks  are  divided  into  three  groups  in  such  a  way 
as  to  place  banks  of  similar  'capitalization  in  each. 
Each  bank  has  one  vote,  irrespective  of  its  size.  The 
group  division,  however,  prevents  the  small  banks  from 
electing  men  who  represent  them  exclusively  and  insures 
approximately  equal  representation  to  banks  of  some- 
what smaller  size.  The  directors  in  question  are  ap- 
pointed for  equal  terms  of  three  years  each,  but  these 
terms  are  so  arranged  that  two  directors  go  out  of 
office  each  year,  thus  insuring  opportunity  for  rotation. 

The  chairman  of  the  board  of  directors  is  designated 
by  the  government  and  is  the  Federal  Reserve  Agent  of 
the  bank.  The  Federal  Reserve  Agent  is  aided  by 
another  officer  known  as  the  Assistant  Agent,  confirmed 
by  the  Board.  The  Federal  Reserve  Agent  is  one  of  the 
Class  C  directors.  The  remaining  Class  C  directors, 
sometimes  described  as  the  "miattached"  directors, 
have  no  specific  functions  other  than  those  assigned  to 
any  director  of  the  bank. 


FEDERAL  RESERVE  OPERATION    451 

V.  Federal  Reserve  Agent. 

Reference  has  already  been  made  to  the  Federal 
Reserve  agent.  As  chairman  of  the  board  of  directors, 
his  function  is  to  preside  over  meetings  of  the  board 
and  in  general  to  perform  all  those  functions  of  organi- 
zation which  ordinarily  fall  to  the  chairman  of  a  delib- 
erative body.  As  representative  of  the  government  in 
his  capacity  of  Federal  Reserve  agent,  he  communi- 
cates with  the  Federal  Reserve  Board  and  transmits 
communications  from  that  body  to  the  bank.  He 
also  acts  in  a  fiduciary  capacity,  receiving  from  the 
board  at  Washington  the  notes  ready  for  circulation  in 
such  amounts  as  the  bank  deems  to  be  necessary,  and 
issuing  or  transferring  these  to  the  bank  whenever  the 
institution  has  placed  with  him,  for  the  special  protec- 
tion of  such  notes,  commercial  paper  of  the  kinds  speci- 
fied in  the  Federal  Reserve  Act  as  eligible  for  rediscount. 
It  is  his  duty  to  report  regularly  to  the  Federal  Reserve 
Board  upon  prevailing  banking  and  commercial  condi- 
tions in  his  district  and  to  inform  the  board  of  any 
special  or  unusual  conditions  demanding  attention  from 
the  governing  body. 

An  important  function  which  falls  to  the  Federal 
Reserv^e  agent  is  that  of  advising  the  board,  whenever 
necessary,  that  the  bank  desires  to  change  the  rate  of 
discount  on  commercial  paper.  If  such  application  for 
change  is  approved,  the  Reserve  agent  notifies  his  bank 
and  announces  the  rates  thus  newly  fixed  to  the  pubhc. 
Beyond  these  definite  and  well-recognized  functions,  the 
duties  of  Federal  Reserve  agent  vary  somewhat  from  bank 
to  bank,  according  to  the  personaUty  of  the  agent  himself. 

VI.  The  Federal  Advisory  Council. 

The  Federal  Reserve  Act  creates  an  advisory  council 
consisting  of  as  many  members  as  there  are  Federal 


452  BANKING  AND   BUSINESS 

Reserve  districts.  It  directs  the  board  of  directors  of 
each  Federal  Reserve  bank  to  select  annually  from  its 
own  district  one  member  of  this  council.  The  council 
shall  meet  at  least  four  times  a  year  at  Washington, 
D.  C,  anrl  oftener  if  called  by  the  Federal  Reserve 
Board.  The  council  at  its  own  discretion  may  hold 
additional  meetings  at  Washington  or  elsewhere. 

The  council  is,  as  its  name  implies,  simply  an  ad- 
visory body  which  confers  directly  with  the  Federal 
Reserve  Board  on  general  business  conditions  and  may 
call  for  information  or  make  recommendations  concern- 
ing Federal  Reserve  banking  operations  to  the  Federal 
Reserve  Board. 

VII.  Outside  Membership  in  the  Federal  Reserve 
System.^ 

When  the  Federal  Reserve  Act  was  first  projected  it 
was  not  intended  to  include  in  the  system  banks  or 
companies  organized  under  non-national  charters.  Many 
state  bankers  and  trust-company  managers,  however, 
promptly  perceived  the  advantages  to  accrue  from  the 
new  system,  and  there  was  an  immediate  and  strong 
demand  for  membership  provisions  applicable  to  their 
companies.  The  Act  as  adopted,  therefore,  made  pro- 
vision for  admitting  to  membership  state  banks  and 
trust  companies  upon  terms  and  conditions  to  be  pre- 
scribed by  the  Federal  Reserve  Board.  Not  a  few  appli- 
cations for  membership  were  at  once  filed,  but  influen- 
tial trust-company  leaders  feared  that  the  provisions 
for  getting  out  of  the  system  were  not  sufficiently  clear — 
that,  while  it  might  be  easy  enough  to  enter,  it  might 


^The  following  pages  in  this  chapter  are  in  large  measure  taken  by 
permission  of  Messrs.  Macmillan  Co.,  publishers  of  The  Modern  Trust 
Company  (Kirkbride,  Sterrett,  &  Willis) ,  from  a  chapter  in  that  volume 
written  by  H.  P.  Willis. 


FEDERAL  RESERVE  OPERATION    453 

be  difficult  to  withdraw.  To  relieve  this  fear  the  Federal 
Reserve  Board  promptly  adopted  liberal  regulations 
governing  application  for  membership  and  withdrawal 
of  state  institutions.  Yet  both  state  banks  and  trust 
companies  entered  the  system  very  slowly.  Accord- 
ingly, Congress  determined  to  amend  the  Act,  and  on 
June  21,  1917,  an  Act  was  passed  whereby  the  regula- 
tions adopted  by  the  board  were  incorporated  into  the 
statute  and  were  thus  given  the  force  of  law.  The 
United  States  had  become  a  belligerent  on  the  side  of 
the  Allies  in  the  war  against  Germany  at  about  the  same 
time  that  the  amendment  to  the  Reserve  Act  was  taken 
under  advisement.  The  impulse  was  therefore  strong 
to  enter  the  system  out  of  considerations  of  patriotism 
and  desire  to  present  a  united  financial  front  to  the 
enemy  during  the  struggle.  Coupled  with  patriotic  con- 
siderations, the  now  highly  favorable  terms  of  member- 
ship and  the  natural  wish  to  secure  the  protection  of 
the  Federal  Reserve  Bank  organization  brought  many 
state  banks  and  trust  companies  into  the  system.  The 
total  number  of  such  state  institutions  on  December  31, 
1921,  was  1,624,  among  which  were  some  of  the  strong- 
est and  largest  banks  and  trust  companies  in  the 
country. 

The  Federal  Reserve  Board  under  the  provisions  of 
the  law  has  developed  a  detailed  method  of  procedure 
in  passing  upon  applications  for  admission  to  the 
system. 

The  only  indispensable  requirements  laid  down  in  the 
law  as  conditions  of  the  membership  of  a  state  institu- 
tion in  the  Federal  Reserve  system  are  that  it  shall  be 
in  sound  condition  and  shall  possess  a  paid-up  unim- 
paired capital  adeciuate  to  entitle  it  to  become  a  national 
bank  in  the  place  where  it  does  business.  Specifically 
this  latter  requirement  is  as  follows: 


454  BANKING  AND  BUSINESS 

Places  with  population  up  to  3,000 $  25,000 

Places  with  i)opulation  over  3,000,  but  not 

over  0,000 50,000 

Places  with  population  over  6,000,  but  not 

over  50,000 100,000 

Places  with  pop.ulation  over  50,000 200,000 

The  requirement  that  the  institution  be  in  sound 
condition  has  been  apphed  by  the  Federal  Reserve 
Board  in  a  clause  of  the  regulations  governing  admis- 
sions which  states  that  the  board  will  consider  in  con- 
nection with  each  prospective  member,  its  financial 
condition,  the  general  character  of  its  management,  and 
whether  or  not  the  corporate  powers  exercised  by  it 
are  consistent  with  the  purposes  of  the  Federal  Reserve 
Act.  It  is  not  true,  as  supposed  by  many,  that  member- 
ship in  the  system  implies  the  surrender  of  charter 
powers  or  the  acceptance  of  new  and  rigid  limitations 
upon  business.  Under  the  terms  of  the  Act,  state  mem- 
bers are  members  in  the  full  sense  of  the  word,  and  hence 
are  naturally  subject  to  the  regulations  and  restrictions 
which  affect  all  members,  as  well  as  to  the  special  regu- 
lations which  may  be  laid  do'^n  by  the  board.  As  a  mat- 
ter of  fact,  however,  the  board  in  admitting  state  mem- 
bers has  seldom  or  never  required  any  material  changes 
in  the  scope  of  their  business,  although  in  various  cases 
where  very  broad  powers  were  being  exercised  it  has  re- 
quired the  appUcant  to  undertake  that  it  would  not  in  the 
future  seek  to  exercise  any  new  or  additional  functions 
without  first  obtaining  the  permission  of  the  Federal 
Reserve  Board.  It  may  be  broadly  stated  that  the 
only  conditions  directly  operating  to  keep  a  bank  from 
joining  the  system  would  be  too  limited  a  capital,  poor 
financial  condition,  or  incompetent  or  doubtful  manage- 
ment. This,  of  course,  does  not  mean  that  companies 
which  fail  to  join  may  not  have  other  and  sound  reasons 
for  their  decision.     It  does  mean  that,  except  where 


FEDERAL  RESERVE   OPERATION    455 

the  company's  capital  is  below  825,000,  there  is  no 
necessity  for  remaining  outside  the  system  if  the 
managers  of  an  institution  wish  to  enter  it.  The  ques- 
tion of  admitting  the  very  small  institutions  has  been 
considered,  but  thus  far  opinion  has  not  been  favorable. 
The  state  institution  which  has  determined  to  enter 
the  Federal  Reserve  system  first  signifies  its  intention 
through  a  resolution  of  its  board  of  directors  in  some- 
what the  following  form: 

Whereas,  it  is  the  sense  of  this  meeting  that  application  should 
be  made  on  behalf  of  this  corporation  for  stock  in  the  Federal 
Reserve  bank  of  in  accordance  Mith  the  pro- 
visions of  the  Federal  Reserve  Act  and  the  regulations  of  the  Fed- 
eral Reserve  Board  made  in  pursuance  thereof; 

And  whereas,  six  per  cent  of  the  paid-up  capital  and  surplus  of 
this  corporation  amounts  to  S ; 

Now,  therefore,  he  it  resolved,  That  the  president  or  xnce-president 
and  the  cashier  or  secretary  of  this  corporation  be  and  they  are 
hereby  authorized,  empowered,  and  directed  to  make  appUcation 

for  and  to  subscribe  to   shares,  of  a  par  value  of 

$100  each,  of  the  capital  stock  of  the  Federal  Reserve  bank  of 

,  to  pay  for  such  stock  in  accordance  with 

the  provisioixs  of  the  Federal  Resers'e  Act,  and  to  agree  for  and 
in  behalf  of  this  corporation  to  comply,  upon  receipt  of  the  approval 
of  this  apphcation  by  the  Federal  Reserve  Board  and  its  accept^ 
ance  by  this  corporation,  with  all  the  requirements  of  the  Federal 
Reserve  Act  and  the  regulations  of  the  Federal  Reserve  Board 
made  in  pursuance  thereof  which  are  apphcable  to  state  banks 
and  trust  companies  which  become  members  of  a  Federal  Reserve 
bank. 

Correspondence  with  the  Federal  Reserve  agent 
(chairman  of  the  board  of  directors  of  the  Fetleral 
Reserve  bank)  of  the  district  may  precede  or  follow  the 
adoption  of  this  resolution  and  results  in  furnishing 
the  applicant  company  with  a  form  designed  to  describe 
the  applicant.  The  Federal  Reserve  agent  may  call 
for  information  on  additional  points  if  circumstances 
seem  to  require,  but  ordinarily  the  bank  will  merely 

30 


45G  BANKING  AND   BUSINESS 

fill  out  the  application  form  and  prepare  a  certified 
copy  of  its  statement  of  condition  on  a  recent  date, 
and  a  copy  of  its  charter  and  articles  of  incorjDoration 
with  all  amendments  up  to  date,  and  transmit  the 
papers  to  the  Federal  Reserve  agent.  The  latter 
officer  has  meantime  probably  made  inquiry  as  to  the 
general  standing  of  the  institution  and  has  usually 
requested  the  state  banking  superintendent  or  com- 
missioner for  copies  of  the  last  report  of  examination 
of  the  concern.  Having  satisfied  himself  by  a  study 
of  the  papers  that  the  applicant  will  probably  be  a 
desirable  member,  he  may  next  institute  an  examina- 
tion of  the  bank.  A  report  of  such  examination 
together  with  the  papers  already  described  is  then 
forwarded  to  the  Federal  Reserve  Board  for  action. 
The  board  refers  the  documents  to  its  Division  of 
Examination  for  study,  and  upon  receiving  the  divi- 
sion's report,  either  accepts  or  rejects  the  application. 

A  state  institution  occasionally  hesitates  to  apply 
for  membership,  fearing  that  through  technical  defects 
in  the  application  or  unavoidable  conditions  attendant 
upon  its  business  it  may  be  rejected.  It  is  rightly  felt 
that  such  rejection,  if  known  or  surmised  by  com- 
petitors of  the  company,  might  hurt  its  standing  or 
leave  a  bad  record  with  dangerous  possibilities  for  the 
future.  There  is,  however,  little  or  no  basis  for  such 
fears.  Long  before  the  time  comes  for  formal  action 
by  the  board  the  applicant  will  have  been  advised  of 
reasons  (if  such  exist)  for  considering  its  admission 
impossible.  In  many  cases  such  obstacles  are  easily 
overcome,  and  the  Federal  Reserve  agent  points  out 
the  means  of  eliminating  them.  If  they  are  practicalh' 
ineradicable  the  applicant  will  have  ascei-tained  that 
such  is  the  case  before  it  has  gone  far.  Even  before  its 
board  has  authorized  apphcation  the  state  bank  has 
usually  been  able  to  get  a  preliminaiy  informal  opinion 


FEDERAL  RESERVE  OPERATION    457 

which  is  in  nearly  all  cases  borne  out  by  a  subsequent 
action.  Should  a  bank's  application  pass  the  scrutiny 
of  the  Federal  Reserve  agent  and  receive  his  favorable 
recommendation,  but  be  looked  upon  with  doubt  or 
disfavor  by  the  Reserve  Board,  it  is  customary  to  send 
the  applicant  an  informal  letter  suggesting  that  the 
apphcation  be  withdrawn  pending  the  introduction  of 
changes  along  lines  indicated.  If  the  bank  then  feels 
that  comphance  is  too  onerous  or  expensive  it  can 
request  suspension  of  action  or  withdraw  its  apphca- 
tion entirely. 

Favorable  action  by  the  Reserve  Board  on  an  appli- 
cation for  membership  is  frequently  accompanied  by  a 
statement  of  conditions  or  changes  in  pohcy  to  which 
the  appUcant  will  be  asked  to  assent.  Some  of  the 
conditions  often  made  in  this  way  are  as  follows: 

1.  Elimination  or  limitation  of  certain  Unes  of  paper 

— e.g.,  too  large  real-estate  loans. 

2.  Agreement  not  to  take  on  or  initiate  new  kinds  of 

business  without  consent. 

3.  Restriction  of  acceptance  lines  to  100  per  cent  of 

capital  and  surplus. 

4.  Limitation  of  maximum  loan  to  any  one  person  or 

corporation. 

5.  Miscellaneous  modifications  of  internal  organiza- 

tion or  management. 

These  requirements  have  never  been  considered 
onerous  or  oppressive,  but  if  they  prove  unacceptable 
to  the  applicant  it  may  decline  to  comply  and  may  thus 
automatically  suspend  further  action  on  its  application. 
Assuming,  however,  as  in  the  vast  majority  of  cases, 
that  the  conditions  are  satisfactory,  the  company 
signifies  its  acceptance  of  the  terms  by  letter  or  tele- 
gram, and  the  Reserve  agent  of  the  district  is  so 
advised.     Thereupon  the  company  is  in  position  to 


4o8  BANKING  AND  BUSINESS 

proceed  with  the  details  necessary  to  complete  its 
active  membership  in  the  Reserve  bank  of  its  district. 
Such  entrance  upon  active  membership  involves  as- 
sumption of  the  same  duties  that  devolve  upon  all 
members  and  are  as  follows: 

Subscription  to  stock.  The  new  member  subscribes 
to  the  stock  of  the  Federal  Reserve  bank  of  its  district 
in  an  amount  equal  to  6  per  cent  of  its  own  capital 
stock  and  surplus.  Should  the  member  bank  subse- 
quently increase  or  decrease  its  stock  or  surplus  it 
makes  a  corresponding  change  in  its  holding  of  the 
stock  of  the  Federal  Reserve  bank. 

Payment  of  subscription.  One-half,  or  3  per  cent, 
of  this  subscription  to  the  stock  of  the  Reserve  bank 
is  payable  at  once  in  cash  or  acceptable  exchange,  the 
other  half  remaining  subject  to  call. 

Simultaneously  with  the  payment  of  the  subscription 
to  capital  stock,  the  new  member  must  estabhsh  (and 
thereafter  maintain)  with  the  Reserve  bank  a  ''reserve 
balance"  payable  in  cash  or  acceptable  exchange  as 
follows : 
> 

1.  If  situated  in  a  central  reserve  city,  13  per  cent 

of  its  aggregate  demand  deposits  and  3  per  cent 
of  its  time  deposits. 

2.  If  situated  in  a  Reserve  city,  10  per  cent  of  its 

aggregate  demand  deposits  and  3  per  cent  of 
its  time  deposits. 

3.  If  situated  elsewhere,  7  per  cent  of  its  aggregate 

demand  deposits  and  3  per  cent  of  its  time 
deposits.^ 


»A  "time  deposit"  under  the  Reserve  Act  includes  deposits  payable 
after  thirty  days,  savings  accounts,  certificates  of  deposit  subject  to 
notice  of  thirty  days  or  over,  and  postal  savings  deposits. 


FEDERAL  RESERVE   OPERATION    459 

The  company  is  now  a  full  member  in  regular 
standing. 

VIII.  Privileges  of  Membership. 

The  member  of  the  Federal  Reserve  system  enjoys 
certain  privileges  which  have  been  the  primary  cause 
for  entering  it  and  which  may  now  be  stated  in  detail: 

Power  to  rediscount.  The  member  may  at  any  time 
submit  "eligible  paper"  for  rediscount.  Proceeds  of 
such  discounts  are  carried  to  its  credit  on  the  books  of 
the  Reserve  bank. 

Authority  to  use  transfer  system.  The  "reserve 
account"  of  the  member  is  not  a  "dead "  or  inactive  ac- 
count, but  can  and  should  be  regularly  used  and  drawn 
upon.  The  "required  reserve"  is  merely  the  equiva- 
lent of  the  "minimum  balance"  required  by  many 
banks  of  their  customers.  Regular  deposits  in  the 
Reserve  bank  should  be  made  by  the  member,  and 
when  collected  the  proceeds  are  carried  to  its  credit 
and  offset  checks  drawn  on  its  account.  The  reserve 
account  thus  serves  as  a  medium  for  collections  and 
transfers. 

Privilege  of  calling  for  service.  The  Federal  Reserve 
Board  has  prescribed  a  long  list  of  functions  which 
may  be  performed  by  Reserve  banks  on  behalf  of  their 
members  and  for  the  exercise  of  which  the  members 
are  therefore  entitled  to  call.  Among  these  are  the 
services  of  purchasing  securities,  "checking"  commer- 
cisil  paper,  and  otherwise  performing  the  duties  of  a 
"correspondent."  Not  all  Reserve  banks  have  under- 
taken these  functions  on  an  extensive  scale,  but  their 
work  in  these  directions  may  be  expected  to  grow. 

Receipt  of  dividends.  Every  member  bank  is  entitled 
to  cumulative  dividends  upon  its  Reserve  bank  stock 
at  6  per  cent  per  annum. 


460  BANKING  AND   BUSINESS 

IX.  Duties  and  Obligations  of  Membership. 

The  chief  duties  and  obhgations  of  membership  have 
already  been  made  plain  in  connection  with  the  terms 
and  conditions  of  admission.  The  member  must  hold 
its  investment  in  the  stock  of  the  Reserve  bank  and 
must  maintain  its  reserve  either  by  depositing  or  re- 
discounting.  There  are,  however,  certain  other  obli- 
gations which  grow  partly  out  of  the  provisions  of  law 
and  partly  out  of  regulation  and  custom,  as  follows: 

Examinations.  Under  the  Federal  Reserve  Act  the 
Reserve  bank  or  the  Reserve  Board  may  at  any  time 
order  a  special  examination  of  a  member.  This,  how- 
ever, is  unusual  and  the  practice  is  to  accept  the 
returns  of  state  banking  departments  acting  either 
independently  or  in  co-operation  with  Reserve-system 
examiners. 

Reports.  Three  classes  of  reports  must  be  made  by 
member  banks,  as  follows: 

1.  Semiannual  report  to  the  Reserve  bank  of  the 

district  as  to  earnings  and  dividends. 

2.  Three  reports  each  year  on  call  of  the  Federal 

Reserve  Board,  the  dates  being  usually  identical 
with  those  named  by  state  banking  depart- 
ments. 

3.  Report  each  week  on  reserve  condition. 

Penalty  for  deficiency  of  reserves.  Under  the  Federal 
Reserve  Act  a  Federal  Reserve  bank  may  impose  upon 
members  whose  reserve  accounts  are  below  the  re- 
quired minimum  a  penalty  for  such  deficiency,  which 
they  must  meet.  This  penalty  is  prescribed  by  the 
board  and  is  at  a  rate  equal  to  the  ninety-day  discount 
rate  plus  2  per  cent. 

Free  collection  service.     The  member  must  undertake 


FEDERAL  RESERVE   OPERATION    461 

to  collect  without  charge  to  the  Resen^e  bank  all  local 
items  sent  it  by  the  Reserve  bank. 

X.  Loss  OF  Membership. 

A  nonnational  member  of  a  Federal  Reserve  bank 
may  return  to  its  original  status  as  a  nonmember  or 
outside  institution  in  any  one  of  several  ways  It  may 
consohdate  with  another  under  a  new  charter,  or  it 
may  be  called  upon  by  the  Reserve  Board  to  forfeit 
its  membership  because  of  failure  to  comply  with  law 
or  regulations,  or  it  may  simply  withdraw.  In  the  last- 
named  e\'ent  it  gives  notice  to  the  board  six  months  in 
advance,  and  in  the  ordinary-  course  its  stock  is  can- 
celed and  it  receives  back  an  amount  equal  to  its  paid- 
up  subscription,  plus  one-half  of  one  per  cent  per 
month  from  the  date  of  the  latest  Reserve  bank 
dividend  (not  exceeding  book  value)  plus  the  net  worth 
of  its  reserve  account.  Some  small  companies  have 
already  gone  into  and  out  of  the  Reserve  system  one 
or  more  times,  as  they  felt  that  their  interests  seemed 
to  dictate.  The  operation  involves  little  or  no  difficulty 
or  apparent  loss  of  credit.  It  has  thus  far  never  been 
necessary  to  expel  a  member,  but  some  institutions 
which  have  withdrawn  probably  could  not  regain 
admission  without  further  changes  in  their  methods  or 
their  holding  of  pajDer.  As  in  most  organizations,  it  is 
easier  to  remain  a  member  than  to  withdraw  and  later 
regain  membership. 


CHAPTER  XXVII 

GOVERNMENT  AND   BANKING 

I.    Relationships     Between     Governments     and 
Banks. 

In  almost  all  modern  countries  the  business  of  bank- 
ing has  assumed  a  special  relationship  to  the  govern- 
ment; for  there  has  been  a  tendency  to  exercise  an 
increasing  degree  of  surveillance  over  essential  busi- 
nesses of  all  types,  especially  over  those  which  occupied 
a  predominant  influence.  Banking  would  not  in  any 
case  have  been  exempt  from  this  kind  of  supervision, 
but  the  supervision  of  banking  is  probably  older  than 
that  which  is  exercised  over  most  other  kinds  of  busi- 
ness. Historically  it  may  be  traced  to  the  fact  that  in 
early  modern  times  the  state  had  definitely  assumed 
the  function  of  issuing  money;  while,  when  banking 
first  began  its  modern  development,  the  assumption 
that  bank  notes  were  money  and  that  they  were  there- 
fore to  be  controlled  or  regulated  as  a  matter  of  state 
function  or  duty  was  likewise  generally  accepted. 
Within  more  recent  times,  however,  specific  business 
relationships  between  the  government  and  banking  in- 
stitutions have  come  to  be  definitely  accepted.  Such 
relationships  may  be  regarded  as  assuming  the  follow- 
ing principal  forms: 

1.  In  some  countries  the  government  is  either  whole 
or  part  owTier  of  a  central  banking  institution,  or 
where  it  o^vns  no  stock  it  appoints  the  officers  or 
directors  of  such  a  banking  establishment.     To  such 


GOVERNMENT  AND   BANKING      4G3 

institutions  is  committed  a  sort  of  general  oversight 
over  the  financial  community  at  large.  This  may  be 
informal  in  its  scope,  but  nevertheless  very  thorough. 

2.  Elsewhere  governments  provide  for  the  regular 
examination  and  inspection  of  banks,  giving  pubHcity 
to  their  reports,  and  through  their  officers  requiring 
that  banks  conforai  to  certain  well-marked  legal 
requirements. 

3.  In  practically  all  countries  governments  have 
large  revenues  which  they  must  receive  and  disburse 
through  banking  channels,  and  they  thus  become  cus- 
tomers of  banks  on  a  large  scale.  In  this  capacity, 
their  receipts  and  disbursements  through  the  banks 
have  a  direct  influence  upon  the  position  of  the  whole 
banking  community  and  affect  its  soundness. 

4.  In  some  countries,  too,  the  government  has  un- 
dertaken, either  through  direct  lending  or  through 
guaranteeing  the  operations  of  private  institutions, 
to  furnish  funds  under  specific  conditions  to  individuals 
or  corporations  engaged  in  particular  kinds  of  business 
which  are  supposed  to  be  in  need  of  such  support  or  aid. 

It  is  necessary  to  examine  briefly  these  various  types 
of  relationship  between  governments  and  banks  and  to 
see  how  they  affect  the  general  organization  of  the 
banking  system. 

s 
II.  Government  Ownership  of  Banks. 

Cases  in  which  there  is  complete  or  partial  government 
ownership  of  banking  institutions  should  probably  be 
considered  as  distinct  from  those  in  which  the  govern- 
ment merely  controls  or  directs  banking  through  the 
appointment  of  officers  or  directors  of  such  institutions, 
yet  the  general  principle  is  the  same  in  both  cases. 
The  latter  kind  of  participation  is  considerably  the 
more  common,  but  the  former  is  still  a  widespread  type 


464  BANKING  AND   BUSINESS 

of  government  activity.  Examples  in  American  his- 
tory may  be  found  in  the  First  and  Second  banks  of 
the  United  States  (see  pp.  390-396),  while  in  con- 
temporary life  perhaps  the  best  illustration  is  afforded 
by  the  Commonwealth  Bank  of  Australia— completely 
owned  and  operated  by  the  goverrmient.  In  the  First 
and  Second  banks  of  the  United  States  the  federal 
government  was  a  minority  stockholder,  controlling 
twenty  per  cent  of  the  shares;  in  the  Commonwealth 
Bank  of  Australia  the  government  is  sole  owner  and 
the  institution  represents  the  government  in  its  finan- 
cial capacity  and  does  a  regular  banking  business  in 
all  branches.  A  somewhat  similar  instance  is  that 
of  the  Philippine  National  Bank  organized  in  1916, 
with  the  government  of  the  Philippines  owning  always 
a  large  majority  of  its  stock.  Among  European  banks 
somewhat  similar  examples,  although  of  a  less  marked 
type,  may  be  found.  In  all  these  cases  the  government 
undertakes  the  business  of  banking  largely  for  the 
purpose  of  controlling  and  regulating  rates  of  interest, 
insuring  what  it  conceives  to  be  a  fairer  distribution  of 
loans,  administering  its  own  funds,  and  supervising  the 
operations  of  the  rank  and  file  of  the  privately  owned 
banks.  As  yet  the  judgment  of  economists  with  refer- 
ence to  public  participation  in  banking  is  not  abso- 
lutely unanimous.  On  the  whole,  however,  the  experi- 
ence of  governments  w^hich  have  thus  participated  in 
direct  banking  operations  has  not  been  very  happy. 
This  does  not  mean  that  business  has  alwaj's  been  car- 
ried on  at  a  loss.  Both  in  the  past  and  at  present, 
governments  w^hich  have  owned  a  part  or  the  whole  of 
large  banking  institutions  have  frequently  profited 
handsomely.  The  difficulties  in  the  way  of  this  kind 
of  government  control  have  grown  out  of  the  fact  that 
the  banks  were  usually  beset  b}-  those  who  desired 
accomimodation  on  a  political  basis,  but  were  unable  to 


GOVERNMENT  AND  BANKING      465 

get  it,  or  they  were  charged  with  having  discriminated 
in  favor  of  or  against  some  element  in  the  community, 
or  in  some  other  way  there  was  furnished  a  ground  for 
attack.  In  sundry  cases  governments  which  have 
yielded  to  political  pressure  have  actually  engaged  in 
unsound  loans,  and  the  banks  in  which  they  were  in- 
terested have  speedily  suffered  the  consequences  of  bad 
banking.  They  could  not  be  saved  from  loss  merely 
because  of  the  fact  that  the  public  was  a  large  stock- 
holder in  them. 

On  the  whole,  the  opinion  has  become  quite  well 
developed  that  if  the  government  is  to  participate  in 
banking  it  will  do  so  to  best  advantage  as  either  a 
minority  stockholder  or  simply  as  a  minority  director, 
acting  through  indi\'iduals  who  are  chosen  to  represent 
it  in  the  latter  capacity.  The  most  striking  example 
of  a  banking  system  in  which  the  government,  without 
being  a  stockholder,  nevertheless  participates  on  a 
minority  basis  in  operation,  is  the  Federal  Reserve 
system.  Through  the  Federal  Reserve  Board  the 
government  of  the  United  States  appoints  one-third 
of  the  directors  of  each  of  the  Federal  Reserve  banks, 
and  it  thus  has  an  indirect  share  in  the  management  of 
these  institutions.  In  some  of  the  European  banks  the 
goverrmient  may  designate  the  chief  officer  or  officers 
and  at  times  a  part  of  the  directors.  The  situation  in 
those  institutions  is  very  similar  to  that  which  exists 
in  the  Federal  Reserve  system.  The  tendency  of  such 
participation  is  merely  that  of  giving  to  the  bank  a 
quasi-public  character,  and  of  assuring  the  rank  and 
file  of  the  people  that  the  institution  is  to  be  operated 
not  for  the  benefit  of  any  particular  group  or  section 
in  the  community,  but  in  the  interest  of  all.  In  the 
main  it  may  be  said  that  the  success  of  this  kind  of 
government  participation  has  been  tolerably  satis- 
factory and  that  it  represents  to-day  the  best  type  of 


466  BANKING  AND  BUSINESS 

relationship  between  the  pubhc  and  the  banks.  It 
should  be  emphasized,  however,  that  success  with  this 
type  of  participation  depends  entirely  upon  the  choice 
of  capable,  public-spirited,  and  well-trained  men  to 
represent  the  government  in  its  banking  functions. 

III.    GOVEKNMENT   SUPERVISION    OF   BaNKS. 

The  second  type  of  participation,  already  enumer- 
ated, is  that  in  which  the  government  is  merely  a 
supervisor  or  director  of  the  various  banks,  and  as  such 
acts  in  a  negative  way  only.  Of  such  supervision  the 
best  example  to  be  found  is  that  afforded  by  the 
national  banking  system  prior  to  the  adoption  of  the 
Federal  Reserve  system,  although  on  a  smaller  scale 
equally  good  examples  are  afforded  by  the  state  banking 
systems  of  the  present  day.  In  all  of  these  (and  in  the 
national  banking  system  as  well)  the  basic  thought 
is  what  is  called  "free  banking."  Individuals  are 
allowed,  under  specified  conditions,  to  apply  for  and  re- 
ceive banking  charters.  Their  operations  as  bankers 
must,  however,  be  governed  by  more  or  less  elabo- 
rately developed  laws.  The  National  Bank  Act,  as 
considered  in  Chapter  XII,  requires  the  maintenance  of 
specified  amounts  of  reserve,  limits  investments  in  cer- 
tain ways,  controls  the  amount  of  loans  that  may  be 
made  to  given  individuals  or  corporations,  and  other- 
wise restricts  the  operations  of  banks.  It  could  not  be 
expected,  in  cases  where  perfectly  free  banking  is  per- 
mitted, that  all  those  institutions  which  are  allowed  to 
operate  would  invariably  comply  with  the  law.  Some 
would  not  do  so  because  of  lack  of  knowledge,  others 
because  they  did  not  fully  understand  or  interpret  the 
requirements  by  which  they  are  surrounded,  while  still 
others  would  fail  because  of  indisposition  to  comply 
with  legal  requirements.     It  is  invariably  necessary, 


GOVERNMENT  AND   BANKING      467 

therefore,  to  have  an  acti\'e  government  officer  who  is 
charged  with  the  duty  of  supervising  the  management 
of  the  banks  and  of  seeing  to  it  that  such  management 
is  in  harmony  with  the  law. 

The  officer  who,  under  the  national  banking  system, 
performs  this  function  is  called  the  Comptroller  of  the 
Currency,  and  in  the  several  states  he  may  be  called 
Superintendent  of  Banking  or  Bank  Commissioner. 
WTiatever  such  an  officer  may  be  called,  his  function, 
as  already  stated,  is  that  of  applying  and  interpreting 
the  law.  In  so  doing  his  method  of  work  is  usually 
that  of  requiring  reports  from  the  different  institutions 
under  his  control  or  of  subjecting  them  to  examination 
at  the  hands  of  bank  examiners,  or  both.  The  reports 
when  completed  are  forwarded  to  the  Comptroller  at 
Washington,  and  in  his  office  are  carefully  analyzed  and 
compared.  If  the  figures  or  the  examiner's  statements 
show  any  violation  of  law,  the  bank  is  promptly  notified 
and  asked  to  refrain  from  objectionable  practices  or  to 
correct  any  methods  that  may  be  objected  to.  In 
other  cases  the  bank  may  simply  be  given  a  letter  of 
advice  indicating  possible  points  of  danger.  Should 
the  bank  fail  to  observe  the  instructions  or  suggestions 
thus  given  to  it,  the  Comptroller  may,  under  certain 
conditions,  apply  for  the  withdrawal  of  its  charter; 
or,  if  evidence  appears  of  criminal  or  illegal  work  on  the 
part  of  officers  of  the  bank,  he  may  undertake  pro- 
ceedings against  them  individually. 

On  the  whole,  this  system  of  oversight  and  reporting 
has  worked  reasonably  well,  the  difficulty  with  it  being 
found  in  its  entirely  negative  character  and  in  the  fact 
that  it  was  not  and  could  not  be  constructi\'e.  These 
defects  were  seen  at  their  worst  during  the  latter  years 
of  the  national  banking  system,  when  sharp  competi- 
tion between  large  banks  entirely  prevented  any  har- 
mony of  action  or  unity  of  purpose  on  the  part  of  the 


468  BANKING   AND   BUSINESS 

institutions  themselves  in  protecting  the  country  against 
disastrous  competition  until  the  moment  for  applica- 
tion of  safeguards  had  passed.  It  was  true  that  when 
the  real  danger  came  upon  the  country  and  a  general 
collapse  of  the  banking  system  was  threatened,  it  was 
usually  possible  to  obtain  a  co-operative  effort  designed 
to  relieve  hard-pressed  banks  and  avoid  a  general 
crumbling  of  the  financial  structure  as  evidenced  in 
bank  failures.  Such  material  aid  was  seen  in  the  form 
of  clearing-house  agreements,  the  issuance  of  clearing- 
house certificates,  and  other  extraordinary  action  of  a 
like  nature.  All  such  necessities  might  have  been 
avoided  had  there  been  constructive  leadership,  but 
this  was  never  provided.  Even  under  the  best  admin- 
istration of  the  Comptroller's  office  there  was  never  any 
possibility  of  restraining  banks,  which  were  technically 
within  the  limits  of  the  law,  from  unduly  extending 
credit,  with  results  which  have  been  sketched  else- 
where in  this  volume.  As  a  result,  therefore,  the 
Comptroller's  office  was  usually  borne  along  with  the 
current  of  banking  development,  his  highest  ideal  of 
success  usually  being  to  keep  the  banks  "clean" — 
that  is  to  say,  free  from  dishonesty,  from  obviously 
irregular  or  excessive  loans,  and  in  as  nearly  sound  a 
general  condition  as  practicable.  But  this  was  a 
rather  low  ideal,  and  one  which  was  far  from  meeting 
the  conditions  of  a  thorough  and  effective  oversight 
of  banking.  Recognition  that  such  was  the  case  was 
the  fundamental  influence  leading  to  the  organization 
of  the  Federal  Reserve  system  with  its  pro\dsion  for 
participation  by,  or  representation  of,  the  pubhc  in 
banking  management. 

What  has  been  said  must  not  be  taken  to  suggest 
that  the  system  of  public  oversight  and  inspection  has 
been  a  failure  or  can  be  dispensed  with,  but  merely  that 
it  is  insufficient.     There  is  still  much   difference  of 


GOVERNMENT  AND  BANKING      469 

opinion  among  authorities  on  banking  as  to  whether 
such  inspection  or  oversight  may  not  be  best  provided 
through  a  central  or  co-operative  mechanism  rather 
than  through  the  efforts  of  governments.  In  the 
United  States  such  difference  of  opinion  was  reflected, 
before  the  organization  of  the  Federal  Reserve  system, 
in  the  action  of  the  clearing-house  associations  in  most 
of  the  larger  cities.  These  associations  usually  had 
as  one  of  their  most  important  functions  the  institution 
of  examinations  for  their  own  members.  Effort  was 
made  to  have  the  clearing-house  examiner  a  non- 
partisan functionary,  entirely  independent  of  any  par- 
ticular institution,  and  simply  acting  as  a  general 
regulator  whose  duty  it  was  to  bring  to  the  attention 
of  the  clearing-house  committee  concUtions  which  were 
likely  to  prove  bad  or  dangerous  from  the  standpoint 
of  banking  as  a  whole.  In  some  cities  this  clearing- 
house system  or  plan  of  mutual  examination,  when  at 
its  best,  was  a  good  deal  more  effective  than  that  of  the 
Comptroller's  office,  though  it  was  always  plain  that 
this  method  of  inspection  would  not  have  worked  well 
outside  of  the  larger  cities.  Country  banks  were  not 
rich  enough  or  harmonious  enough  to  employ  it  for 
themselves ;  so  that  in  practice  the  government  syst^em 
of  inspection  was  always  necessary.  In  the  Federal 
Reserve  Act,  provision  was  made  for  the  examination 
of  member  banks  by  Federal  Reserve  banks  if  the 
latter  found  it  necessary.  The  exercise  of  this  function 
has  been  more  or  less  in  abeyance  because  of  the  fact 
that  the  Comptroller's  powers  still  continue  to  be 
exercised,  but  at  any  time  the  transfer  of  examination 
work  might  easily  be  effected. 

Were  it  to  be  thus  effected,  examination  would  prac- 
tically be  placed  upon  a  mutual  basis  and  the  banks 
would  be  in  the  position  of  looking  after  their  own 
affairs,  public  opinion  and  the  general  ethics  of  the 


470  BANKING  AND  BUSINESS 

profession  establishing  an  average  standard  of  conduct 
which  must  be  observed.  In  foreign  countries  pubhc 
examination  and  inspection  has  never  made  much 
headway.  Its  place  has  been  taken  by  careful  reports 
rendered  by  the  banks  to  the  government  as  the  result 
of  the  process  of  self-examination,  or  through  clearing- 
house examinations,  or  through  examinations  carried 
on  by  certified  accountants,  which  no  bank  was  com- 
pelled to  carry  through,  but  which,  nevertheless,  were 
exacted  by  public  opinion.  It  may  be  said  that  the 
prevailing  European  type  of  examination,  so  far  as  any 
can  be  said  to  exist,  is  the  statement  method,  and  that 
the  negative  work  done  by  such  officers  as  the  Comp- 
troller of  the  Currency  or  Superintendent  of  Banks  in 
the  United  States  is  superseded  by  positive  control 
proceeding  from  the  central  bank  and  applied  through 
the  mechanism  of  the  discount  market.  In  efTect  this 
means  that  the  banks  must  maintain  themselves  in  a 
sound  condition;  otherwise  they  will  be  unable  to 
obtain  rediscount  accommodation  from  the  central 
bank.  Bad  banking  is  thus  penahzed  not  by  legal 
proceedings  or  official  reprimands,  but  by  refusal  to 
provide  further  -credit  for  the  use  of  those  banks  which 
are  guilty  of  the  practices  complained  of. 

IV.  Government  as  a  Depositor  of  Banks. 

The  third  elementary  type  of  relationship  between 
government  and  banking  system,  already  referred  to 
at  the  opening  of  this  chapter,  was  seen  in  the  fact  that 
the  government  is  itself  a  large  depositor,  and  is  there- 
fore able  to  exercise  over  all  banks  that  kind  of  control 
which  customers  always  exercise,  whether  in  public  or 
in  private  life,  over  the  concerns  with  which  they  trade. 
The  government  of  the  United  States  is  to-day  the 
greatest  business  enterprise  and  the  largest  depositor 


GOVERNMENT  AND   BANKING      471 

in  the  country.  Much  the  same  is  true  of  all  modern 
nations,  and  it  is  everj^vhere  a  fact  that  the  volume  of 
taxation  and  other  revenue  flowing  into  the  public 
coffers,  and  usually  flowing  out  quite  as  promptly,  is 
the  largest  single  stream  of  wealth  within  the  national 
borders.  The  question  during  the  past  hundred  years 
has  always  been  urgent,  how  this  wealth  should  be 
handled  and  what  use  should  be  made  of  'it.  Even 
though  it  be  true  that  the  government  has  no  large 
accumulation  of  funds  that  it  does  not  need  at  any 
giA'en  time,  it  is  a  fact  that  there  is  always  in  the 
public  purse  a  great  quantity  of  fluid  funds  which  are 
being  turned  in  one  direction  or  another. 

V.  Direct  Deposit  of  Goverment  Funds. 

Three  methods  in  general  have  been  followed  in  re- 
gard to  the  control  or  management  of  public  funds 
during  the  nineteenth  century.  The  first  and  simplest 
plan  is  that  of  depositing  funds  directly  in  banks,  just 
as  a  private  person  would  dispose  of  his  cash.  This 
was  the  plan  adopted  by  the  government  of  the  United 
States  after  the  expiration  of  the  charter  of  the  First 
Bank  of  the  United  States.  Banks  were  selected  and 
deposits  were  made  with  them  and  payments  were 
effected  by  check.  The  second  method  is  that  of 
selecting  some  one  strong  institution  under  public  con- 
trol, placing  the  funds  ^Wth  it,  and  depending  upon 
it  to  act  as  a  fiscal  agent.  Thii>  plan  has  now  been 
followed  by  such  governments  as  France  and  England, 
the  national  funds  being  deposited  with  the  central 
banks  of  those  countries,  while  disbursements  were 
made  by  check  as  needed.  The  third  method  is  best 
exemplified  by  the  policy  of  the  United  States  from 
about  1846  down  to  1920,  and  is  known  as  the  inde- 
pendent treasury  policy.     Under  it  the  government 


472  BANKING  AND   BUSINESS 

established,  in  its  final  development,  an  elaborate  fiscal 
mechanism  and  extensive  vaults  in  which  the  actual 
money  of  the  public  was  held.  The  government  pre- 
sumably received  only  money,  passed  out  only  money, 
and  did  its  own  banking  by  keeping  the  cash  on  hand 
in  its  own  strong  boxes. 

There  has  been  a  sharp  conflict  of  opinion,  especially 
in  American  literature,  between  these  three  methods  of 
procedure,  and  our  national  experience  has  been  par- 
ticularly rich  in  illustrating  the  working  of  these 
various  plans.  We  have  unifonnly  found  that  the  plan 
of  direct  deposit  in  banks  was  unsound  and  dangerous. 
As  illustrated  by  American  experience,  this  policy 
usually  resulted  in  transferring  funds  from  parts  of  the 
country  and  from  banks  that  were  legitimately  en- 
titled to  them  because  of  their  business  requirements, 
to  other  parts  of  the  country  which  were  not  so  en- 
titled to  hold  them.  As  a  result  there  was  a  tendency 
toward  the  stimulation  of  unsound  loans,  and  business 
was  often  inflated  by  extensions  of  credit  that  ought 
not  to  have  been  made  at  all,  so  that  at  times  the 
government  found  it  difficult  or  impossible  to  call  back 
its  own  funds  without  embarrassing  the  depository 
banks  and  so  causing  a  panic.  A  notable  experience 
of  this  kind  occurred  after  the  termination  of  the 
charter  of  the  Second  Bank  of  the  United  States,  during 
the  period  subsequent  to  1837.  This  experience,  how- 
ever, differed  only  in  severity  and  intensity  from  the 
similar  experiences  which  had  been  had  at  other  times 
and  in  other  countries.  It  is  enough  to  say  that  gov- 
ernment officials  seldom  select  banks  as  depositories 
wisely,  and  that  even  when  they  do  the  amounts  that 
they  have  to  transfer  are  so  great  that  the  business 
is  likely  to  be  beyond  the  strength  of  the  ordinary 
commercial  bank.  There  is  thus  a  temptation  to 
divide  the  funds  up  into  small  amounts  and  to  dis- 


GOVERNMENT  AND   BANKING      473 

tribute  them  politically,  refraining  from  drawing  upon 
those  institutions  that  are  best  able  to  protect  them- 
selves against  any  use  of  the  funds  by  the  exertion  of 
their  influence. 


VI.  Independent  Holding  of  Government  Funds. 

The  method  of  independent  holding  of  pubhc  funds 
as  provided  for  by  the  Independent  Treasury  Act  of 
1846  was  originally  bottomed  upon  the  notion  that 
the  government  should  accept  nothing  but  specie  and 
should  pay  out  nothing  but  specie.  It  was  intended 
to  be  a  "hard-money"  policy.  This  plan  has  proved 
its  w^eakness  both  in  time  of  war  and  in  peace,  the 
effect  of  it  being  always  to  draw  suddenly  upon  the 
banking  mechanism  of  the  country  for  cash  or  to  pour 
cash  back  as  suddenly  into  places  where  such  cash  was 
not  wanted.  The  effect  was  somewhat  different  from 
that  of  the  sudden  withdrawals  or  sudden  payments 
under  the  individual  bank-deposit  plan,  but  it  was  even 
more  disastrous  than  the  former.  For  example,  in 
American  experience  it  was  found  that  even  in  time  of 
peace,  when  surpluses  of  revenue  had  been  accumulated, 
the  result  was  to  make  an  undue  reduction  in  the  supply 
of  money  in  the  country,  while  when  deficits  occurred 
there  was  an  undue  outflow  of  money. 

VII.  Effect  of  Withdrawal  of  Cash. 

The  continuous  fluctuation  in  the  supply  of  money 
which  grew  out  of  such  variations  in  public  revenue 
was  bad  enough  in  its  way  and  undoubtedly  con- 
tributed in  an  important  degree  to  the  regular  annual 
stringencies  which  in  former  years  were  a  feature  of 
American  banking.  These,  however,  were  not  to  be 
compared  in  their  injurious  effect  with  the  evils  of  the 


474  BANKING   AND   BUSINESS 

working  of  the  independent  treasury  system  in  time  of 
war.  As  is  well  known,  the  great  financial  demands  of 
governments  in  times  of  modern  war  invariably  strain 
the  financial  mechanism  to  its  utmost,  and  it  may 
often  be  true  that  a  single  loan  amounts  to  more  than 
the  entire  supply  of  money  in  a  country.  This  was 
true  of  one  or  more  loans  both  in  the  United  States 
and  in  Great  Britain  during  the  World  War,  when 
upward  of  $5,000,000,000  was  subscribed  as  the  result 
of  a  single  offering.  Any  effort  to  collect  great  sums  in 
actual  coin  is  necessarily  disastrous,  because  it  ex- 
hausts the  cash  reserves  of  the  banks  and  thereby 
drives  them  into  a  condition  of  suspension.  At  the 
time  of  the  Civil  War  the  cost  of  hostilities  was  not 
nearly  so  large,  relatively  or  absolutely,  as  it  became 
fifty  years  later,  but  the  size  of  the  loans  was  sufficient 
to  compel  bank  suspension  as  a  result  of  the  effort  to 
collect  the  subscriptions  in  cash.  In  fact,  the  inde- 
pendent treasury  system  had  to  be  practically  laid 
aside  during  the  four  years  of  the  Civil  War,  so  disas- 
trous was  its  working,  and  after  the  war  it  had  to  be 
seriously  modified  in  practical  use  by  permitting 
the  deposit  of  inactive  funds  in  national  banks  pro- 
tected by  deposits  of  government  bonds  with  the 
Treasury.  This  plan,  however,  was  never  satisfactory; 
and  when  the  Federal  Reserve  Act  was  adopted  pro- 
vision was  made  for  constituting  the  Federal  Reserve 
banks  agents  of  the  government.  The  coming  on  of 
the  European  War,  and  later  our  own  participation  in 
it,  compelled  the  Secretary  of  the  Treasury  to  avail 
himself  of  the  means  thus  held  out  to  him  for  moderniz- 
ing the  system  of  the  government  and  for  putting  the 
Treasury's  relations  wdth  banks  upon  a  business  basis. 
In  this  respect,  the  practice  of  the  United  States  is 
to-day  practically  in  harmony  with  that  of  the  chief 
European  countries. 


GOVERNMENT  AND   BANKING      475 

VIII.  Relation  to  Central  Bank. 

In  all  modern  countries  at  the  present  time,  accord- 
ingly, the  plan  has  been  developed  for  placing  the 
government's  funds  in  a  single  strong  bank;  and  as  a 
rule  the  central  banking  organization  of  the  country- 
has  been  chosen  to  exercise  this  function.  Elsewhere 
in  this  volume  it  has  been  shown  that  the  central  bank 
of  the  nation  is  in  essence  a  bankers'  bank.  As  things 
have  developed,  the  relation  of  the  government  to  the 
banks  as  depositor  has  thus  practically  developed  into 
a  system  whereby  taxes,  duties,  and  other  public  dues 
are  paid  in  bank  credit.  Under  our  income-tax  law, 
for  example,  a  taxpayer  remits  to  the  collector  of  in- 
ternal revenue  a  check  on  his  o^n  bank.  Such  checks 
are  deposited  vaih.  a  Federal  Reserve  bank  and  eventu- 
ally result  in  transferring  a  credit  from  the  account 
of  the  depositor  in  the  individual  bank  to  the  account 
of  the  government  in  the  Federal  Reserve  bank.  The 
payment  is  thus  no  longer  made  in  money,  but  in  bank 
credit,  and  the  credits  of  the  government  are  carried 
on  the  books  of  the  central  bank.  The  "hard-money" 
policy  is  thus  entirely  abandoned,  while  even  paper 
money  is  but  little  used  in  making  settlements.  Pay- 
ments take  place  in  book  transfers,  just  as  is  the  case 
with  large  settlements  involving  private  enterprises. 
This  modern  method  of  transacting  the  government's 
business  amounts  to  giving  to  the  public  authorities 
the  right  to  dip  into  the  community's  store  of  wealth, 
transferring  it  to  creditors  as  may  be  necessary',  but 
disturbing  the  underlying  reserves  only  in  a  minimum 
degree.  There  would  seem  to  be  no  reason  to  suppose 
that  the  other  plans  already  described  will  make  head- 
way again  in  practice.  It  should  be  carefully  obserA'ed, 
however,  that  when  the  government  becomes  a  large 
depositor  in  any  banking  institution  it  naturally  as- 


476  BANKING  AND   BUSINESS 

sumes  a  much  closer  relationship  to  such  an  institution 
than  it  otherwise  would,  the  result  being  that  it  in- 
e\itably  assumes  on  thi^account,  if  on  no  other,  a 
right  and  duty  of  oversight  or  control  which  it  might 
not  otherwise  feel  called  upon  to  undertake. 

IX.  Special  Financial  Aid  to  Producers. 

As  already  seen,  the  relationship  between  the  gov- 
ernment and  the  banking  system,  as  well  as  the  bank- 
ing relationship  of  the  government  to  the  public,  in- 
cludes a  fourth  type  which  deserves  careful  study.  In  a 
good  many  countries  there  has  been,  especially  in  re- 
cent years,  a  strong  growth  of  the  idea  that  certain 
classes  of  producers,  weak  industries,  or  businesses 
that  were  supposedly  vested  with  a  public  interest, 
deserve  special  attention  and  support.  Perhaps  the 
best  illustration  of  the  kind  is  seen  in  the  case  of 
agriculture.  Farmers  in  many  countries  have  been 
able  to  put  pressure  upon  governments  in  order  to  secure 
the  extension  of  credit  to  them  upon  terms  or  condi- 
tions that  might  not  be  granted  to  others.  The  conse- 
quence of  this  demand  has  been,  in  some  cases,  to 
bring  about  the  establishment  of  institutions  whose 
function  it  was  to  furnish  special  banking  or  credit 
facilities  for  agriculture.  Thus  the  United  States  pro- 
vided for  the  incorporation  of  farm-loan  banks  in  1915, 
and  purchased  the  entire  stock  of  ther^e  banks  out  of 
public  funds,  while  it  later  became  a  very  large  bond- 
holder by  purchasing  the  bonds  issued  by  these  banks. 
Still  later,  during  the  war,  when  it  was  alleged  that 
given  classes  of  industry  could  not  obtain  the  credit 
support  that  they  needed,  the  government  organized 
the  War  Finance  Corporation  with  the  function  of 
discounting  slow  and  long-term  paper.  In  1921  it  re- 
modeled the  War  Finance  Corporation  by  an  amenda- 


GOVERNMENT  AND  BANKING      477 

tory  act  (other  amendments  having  been  adopted  in 
preceding  years),  so  that  the  institution  could  exert 
itself  in  promoting  the  exportation  of  agricultural 
products  to  foreign  countries  in  those  cases  which 
offered  special  reasons  for  govenmient  aid  of  this  kind. 
In  other  countries,  somewhat  similar  measures  have 
from  time  to  time  been  taken.  Great  Britain,  for 
example,  after  the  close  of  the  war,  organized  an  export 
credit  plan  whose  object  it  was  to  relieve  bankers  of 
the  habihty  growing  out  of  unduly  hazardous  elements 
in  the  export  trade.  Various  instances  might  be  cited 
of  action  on  the  part  of  other  nations  intended  to 
afford  special  credit  accommodations  either  to  facilitate 
particular  movements  of  goods  or  to  help  out  special 
classes  in  the  community.  It  is  not  necessary  to  go 
into  the  detail  of  these  dilTerent  organizations,  but 
their  general  characteristics  should  be  noted.  This  is 
found  in  the  fact  that  they  constitute  a  diversion  of 
capital  from  the  channels  in  which  it  would  naturally 
flow  to  others  into  which  it  has  been  diverted  by 
government  intervention  and  guaranties.  The  result 
is  to  transfer  a  part  of  the  normal  credit  risks  of  the 
country  out  of  the  hands  of  the  banks,  and  so  saddle 
them  upon  the  shoulders  of  the  community  as  a  whole 
represented  in  the  governmental  mechanism. 

It  is  probable  that  the  relationship  between  the 
government  and  the  banking  mechanism  in  modern 
countries  will  grow  closer  and  more  intimate  in  future 
years.  This  makes  it  the  more  important  to  recognize 
the  consequences  of  such  interference  and  especially 
to  note  the  influence  exerted  by  government  banking 
schemes  upon  the  general  credit  structure. 


CHAPTER  XXVIII 

PRICES,   MONEY,  AND  BANKING 

I.  Relation  of  Money  to  Bank  Credit. 

In  preceding  chapters  reference  has  often  been  made 
to  money,  with  only  a  passing  explanation  of  its  func- 
tions and  uses.  The  most  extensive  reference  that 
has  been  made  to  it  in  its  relation  to  banking  is  found 
in  the  section  dealing  with  reserves,  where  the  thought 
was  developed  that  one  problem  in  connection  with 
the  reserves  of  the  bank  is  that  of  providing  always  a 
sufficient  amount  of  specie  with  which  to  meet  current 
obhgations  that  may  be  presented.  Nothing  has  been 
said  with  regard  to  the  theory  of  money  or  prices, 
because  of  the  behef  that  this  phase  of  the  subject 
can  best  be  dealt  with  after  the  reader  has  attained 
a  working  knowledge  of  the  methods  of  banking.  It 
is  now  time,  however,  to  set  forth  some  of  the  main 
problems  of  money  in  its  relation  to  bank  credit. 

As  has  been  seen  incidentally  at  an  earlier  point, 
money  is  by  many  regarded  as  having  been  a  develop- 
ment in  the  process  of  exchange  which  preceded  credit 
and  which  certainly  preceded  even  the  most  funda- 
mental forms  of  banking.  Without  stopping  to  in- 
quire further  into  the  historical  accuracy  of  this  view 
of  the  situation,  it  may  be  admitted  that  the  exchange 
of  goods  largely  by  the  use  of  money  is  a  step  in  the 
process  of  working  out  the  modern  exchange  system 
which  preceded  any  considerable  development  of  bank- 
ing as  we  know  it  to-day.     Looking  back,  for  example. 


PRICES,   MONEY,   AND  BANKING    479 

for  about  a  century,  it  will  be  found  that  most  civilized 
nations  had  accepted  the  view  that  it  was  the  duty  of 
governments  to  establish  the  standard  of  value,  coin 
money  and  issue  it,  while  it  was  also  true  that  the 
larger  part  of  exchanges  was  consummated  either  im- 
mediately or  eventually  by  the  actual  transfer  of  money 
or  its  paper  representatives.  The  concept  of  a  banking 
system  in  which  transfers  of  credit  on  the  books  of 
banks  took  the  place  of  credit  individually  extended  by 
traders,  and  in  which,  therefore,  the  liability  for  the 
soundness  of  credit  was  shifted  to  the  bank,  has  been 
the  product  of  the  last  three-quarters  of  a  century  or 
less.  This  being  so,  it  was  natural  that  in  the  earlier 
days  of  modern  banking  the  bank  should  be  regarded 
as  an  institution  for  lending  money  or  furnishing 
money,  and  that  its  function  should  be  concei\'ed  of 
very  largely  in  terms  of  the  money  standard.  It  was 
equally  natural  that  the  reserves  of  the  bank  should  be 
considered  as  consisting  of  actual  money,  and  that 
solvency  and  liquidity  on  the  part  of  the  bank  should 
be  regarded  as  measured  by  the  abihty  to  command 
money  when  customers  sought  it.  The  foregoing 
chapters  have  shown  the  erroneous  character  of  this 
idea.  Still  it  remains  true  that,  with  conditions  in  the 
world  as  they  are  at  the  present  time,  money  retains, 
and,  so  far  as  one  can  foresee,  will  continue  to  retain 
for  an  indefinite  period,  an  important  function  as  the 
means  of  liquidating  obligations.  Banks  will  con- 
tinue to  be  tested  by  their  ability  to  command  money, 
and  it  is  probable  that  economists  will  continue  to 
theorize  about  bank  credit  as  a  substitute  for  money 
or  as  a  means  of  avoiding  the  use  of  money. 

It  is  at  the  latter  point  that  the  student  who  enters 
the  field  of  scientific  banking  needs  most  to  clarify  his 
ideas.  As  the  modem  economic  world  has  developed, 
most  of  its  business  transactions  are  in  one  way  or 


480  BANKING  AND  BUSINESS 

another  connected  actually  or  nominally  with  money. 
The  value  of  goods  is  stated  in  terms  of  money  even 
when  the  goods  themselves  are  sold  without  the 
actual  acquirement  of  any  cash  whatever  by  the  seller. 
The  level  of  prices  is  measured  in  terms  of  money  and 
the  problem  of  the  value  of  money  is  thus  fundamental 
in  the  whole  theory  of  exchange,  and  hence  has  a 
vital  relationship  to  banking  both  in  theory  and  in 
practice. 

II.  Meaning  of  the  Value  of  Money. 

WTiat  is  meant  by  the  value  of  money?  The 
significance  of  the  term  can  best  be  understood  by 
regarding  it  as  the  converse  of  the  term  "value  of  com- 
modities." When  we  speak  of  the  price  of  a  given 
group  of  commodities  as  $100  we  mean  that  they  will 
exchange  for  a  quantity  of  money  or  its  equivalent 
expressed  by  the  figure  100.  The  teiTQ  "dollar," 
"pound  sterling,"  "franc,"  would  have  no  meaning 
were  it  not  for  statutes  in  the  countries  whose  stand- 
ards they  are,  requiring  that  they  shall  represent  a 
specified  number  of  grains  of  gold,  or,  in  some  condi- 
tions, of  silver.  The  value  of  conmtiodities  then  may 
be  regarded  as  the  quantity  of  standard  metal,  repre- 
sented by  a  term  legally  defined  (as  dollar,  pound 
sterling,  franc,  etc.),  or  the  equivalent  thereof  in  some 
other  form,  which  they  can  command.  Strictly  speaking, 
however,  the  value  of  commodities  expressed  in  terms  of 
money  is  technically  at  least  the  quantity  of  the 
standard  metal  for  which  they  will  exchange.  Re- 
versing this  conception,  it  is  clear  that  the  value  of 
money  means  the  quantity  of  commodities  for  which 
a  given  unit  or  amount  of  the  precious  metal  which 
is  accepted  as  money  will  exchange.  Thus  in  the  case 
of  the  group  of  commodities  whose  value  was  taken  as 


PRICES,   MONEY,  AND  BANKING  481 

$100  above,  the  value  of  100  is  the  aggregate  of  com- 
modities constituting  the  group  already  referred  to. 
The  difficulty  in  reversing  the  terms  and  using  them 
interchangeably  Hes  in  the  fact  that,  whereas  money 
is  a  single  commodity,  other  items  of  goods  vary. 
Strictly  speaking,  therefore,  the  value  of  money  must 
be  taken  as  the  total  amount  of  all  existing  commodities 
that  can  be  bought  at  a  gi\'en  time,  for  which  a  unit  of 
money  would  exchange.  This  concept,  as  readily 
appears,  is  unwieldy  for  ordinary  use.  Since  we  can 
never  tell  exactly  what  commodities  money  will  be 
offered  for,  and  since  not  all  commodities  are  constantly 
or  freely  bought,  the  term  "value"  of  money  is  very 
much  looser  than  the  term  ''value  of  goods"  or  ''value 
of  commodities." 

III.  Measurement  of  Value  by  Index  Numbers. 

There  must,  however,  be  a  way  of  measuring  the 
value  of  money  and  of  ascertaining  it  at  any  given  time. 
Since  it  is  not  possible  to  measure  or  ascertain  the 
exchange  value  of  money  for  all  commodities  at  any 
given  time,  economists  have  agreed  upon  hsts  of  com- 
modities whose  prices  are  to  be  taken  as  measuring 
the  value  of  money.  Thus,  for  instance,  if  at  any  given 
moment  we  say  that  a  bushel  of  wheat  is  worth  $1, 
a  ton  of  pig  iron  $20,  a  yard  of  cloth  S3. 50,  and  so  on 
up  to  a  total  of  $100,  we  may  say  that  the  value  of  the 
precious  metal  contained  in  $100  is  represented  by  the 
sum  total  of  the  units  of  different  goods  thus  selected 
for  comparison.  The  purpose  of  thus  reversing  the 
idea  of  value  is,  however,  primarily  that  of  making 
possible  comparisons  of  value  at  different  times. 

The  working  of  the  index-number  plan  for  the 
measurement  of  prices  is  comparatively  simple.  Its 
use  is  necessitated  simply  by  the  fact  that  it  is  possible 


482  BANKING  AND   BUSINESS 

to  combine  or  add  dissimilar  units  only  after  reducing 
them  to  a  mathematical  base  or  equivalent.  For  in- 
stance, if  it  be  desired  to  average  the  price  of  ships  and 
clothing  and  vegetables,  no  success  can  be  had  without 
first  getting  a  mathematical  expression  for  each  price. 
The  index-number  plan  involves  further  the  choice  of  a 
definite  base  period  from  which  to  reckon.  For  in- 
stance, assume  that  it  is  desired  to  compare  the  level 
of  prices  in  the  year  1910  with  that  of  the  year  1900. 
The  first  problem  is  to  select  the  commodities  which 
are  to  be  taken  as  representative  of  all  others.  Sup- 
pose that  ten  such  commodities  are  chosen  and  that 
they  are,  say,  pig  iron,  copper,  wool,  woolen  cloth, 
raw  cotton,  cotton  cloth,  wheat,  corn,  anthracite  coal, 
and  a  standard  grade  of  lumber.  Evidently  these 
prices  are  entirely  incomparable.  They  will  run  from, 
say,  $25  a  ton  for  pig  iron  to  $1  a  bushel  for  wheat 
or  $15  a  ton  for  coal.  The  first  step,  therefore,  is  to 
regard  these  various  prices  as  merely  the  base  from 
which  to  figure,  assigning  to  each  one  of  them  an 
abstract  value  of  100.  Evidently,  then,  the  combined 
price  of  these  commodities  in  the  year  1900  will  be 
1,000 — that  is  to  say,  ten  times  100,  the  base  or  equiv- 
alent price  of  each  article.  Now,  if  in  the  year  1910 
pig  iron  instead  of  being  $25  per  ton  is  $30,  the  index 
number  for  that  article  will  be  5-25  above  what  it 
was  in  the  year  1900 — that  is  to  say,  it  will  be  120. 
Again,  if  the  price  of  wheat  was  $1  per  bushel  in 
1900  and  in  the  year  1910  turns  out  to  be,  say,  90  cents 
per  bushel,  there  has  been  a  decline  of  10  per  cent  in 
value,  and  the  index  number  for  that  article  ^\ill  be  90. 
So  also  if  anthracite  coal  has  risen  from  $15  to  $20 
the  index  number  for  the  latter  year  is  133j^.  It  is 
possible  that  in  adding  the  ten  index  numbers  for  the 
year  1910  the  decHnes  in  some  articles  vdW  offset  the 
advances   in   others,    leaving   the   index   number   for 


PRICES,   MONEY,   AND   BANKING   483 

1910  1,000  just  as  it  was  in  1900.  This,  however,  is 
very  unUkely.  The  figures  will  probably  show  an  in- 
crease or  a  decline.  Suppose  it  is  1,100  instead  of 
1,000.  Evidently  the  standard  increase  in  the  general 
level  of  prices  during  the  ten  years  in  question  is 
10  per  cent,  which  we  may  express  by  saving  that; 
with  the  year  1900  as  a  base,  there  has  been  a  10-per- 
cent increase  in  prices  during  the  decade,  leaving  the 
index  number  in  contrast  with  1910  at  110.  It  will  be 
evident  to  the  careful  reader  that  there  are  many 
sources  of  error  in  this  way  of  measuring  prices.  For 
instance,  the  commodities  chosen  as  representative 
may  have  been  badly  selected,  or  consumption  habits 
may  have  changed  during  the  ten  years,  so  that, 
although  they  were  well  chosen  at  the  outset,  they  are 
not  very  representative  in  the  later  year.  There  may 
be  difficulties  in  the  actual  getting  of  the  prices  on  an 
accurate  basis.  Quotations  may  have  been  readily 
available  in  the  earlier  year,  but  difficult  to  obtain  ten 
years  later.  Some  commodities  may  have  gone  out 
of  current  use.  This  is  largely  true  of  cotton  and 
woolen  textiles,  in  which  methods  of  weaving  have 
greatly  altered  during  recent  years.  It  is  also  true 
that  a  simple  arithmetic  average  of  the  kind  used  in 
our  illustration  may  be  open  to  very  serious  question. 
For  instance,  pig  iron  does  not  figure  largely  in  the 
ordinary  consumption  of  the  individual,  while  anthra- 
cite coal  may  be  an  important  element  in  familj' 
expenses,  but  is  only  a  minor  item  of  cost  to  the  in- 
habitants of  a  hot^l.  From  all  this  it  follows  that 
the  index-number  mode  of  measurement  is  always  very 
uncertain  in  its  working,  and  at  the  best  is  never  more 
than  approximate  in  its  adaptation  to  actual  conditions. 
It  is,  however,  the  only  way  of  measuring  general 
changes  in  prices.  It  is  always  possible  to  trace  the 
movement  of  one  particular  price,  but  to  say  that  prices 


484  BANKING  AND   BUSINESS 

as  a  whole  have  risen  or  fallen  is  feasible  only  through 
the  use,  as  already  explained,  of  some  mathematical 
means  of  reducing  them  to  a  common  base.  That  is  the 
service  which  the  index  number  performs,  and  that  is 
the  reason  why  there  has  been  an  increase  in  the  use 
of  these  numbers— they  render  possible  comparisons 
which  otherwise  would  be  out  of  the  question.  In 
some  sets  of  index  numbers  there  are  employed  elab- 
orate mathematical  methods  of  computation  designed 
to  allow  for  or  to  ehminate  error.  These  may  have  a 
more  or  less  sound  base  and  hence  may  be  more  or  less 
desirable.  The  general  opinion  of  writers  on  the  sub- 
ject undoubtedly  is  that  elaborate  mathematical  modi- 
fications in  methods  of  computing  index  numbers  have 
not,  on  the  whole,  justified  themselves  and  that  the 
simple  arithmetic  plan  of  computation  is  on  many 
occasions  the  best  plan,  while  in  others  the  introduction 
of  mathematical  refinements  must  be  sought  only 
after  the  most  careful  analysis  of  the  various  factors 
entering  into  the  problem. 

IV.  Quantity  Theory  of  Money. 

The  question  whether  the  supply  of  money  directly 
influences  prices,  and  if  so  to  what  extent,  has  figured 
prominently  in  economic  discussions  for  many  years. 
The  so-called  classical  economists  early  evolved  what 
was  called  the  quantity  theory  of  money.  This, 
roughly  stated,  was  to  the  effect  that,  as  the  supply 
of  money  increased,  the  money  value  of  commodities 
tended  to  increase.  As  thus  stated  the  doctrine  was 
little  but  a  truism,  but  it  was  a  direct  and  natural 
inference  that  in  order  to  raise  prices  it  was  only 
necessary  to  increase  the  supply  of  money,  while 
in  order  to  reduce  them  or  to  hold  them  in  check 
it  was  only  necessary  to  curtail  the  supply  of  money. 


PRICES,   MONEY,  AND  BANKING  485 

The  theory  was  not  very  important  in  its  direct 
bearings  so  long  as  the  term  "money"  was  limited  to 
the  strict  and  original  meaning  of  the  term — standard 
money,  or,  in  a  country  on  a  specie  basis,  the  standard 
money  metal.  As  there  was  no  artificial  way  of  in- 
creasing the  supply  of  money  metal  excejjt  by  producing 
it,  the  basis  of  prices  was  thus  given  a  kind  of  "natural " 
foundation. 

Closely  connected  with  this  view  of  the  price  situa- 
tion was  the  theory  of  international  trade,  which  was 
worked  out  by  classical  economists  in  complete  form. 
This  trade  theory  held  to  the  view  that  exports  and 
imports  over  a  sufficiently  long  period  were  equal,  and 
that  since  "visible"  exports  and  imports  consisted  of 
(a)  goods  and  (b)  money,  a  favorable  balance  of  trade 
(excess  of  exports  over  imports)  meant  a  larger  incom- 
ing supply  of  money  in  order  to  e(iuaUze  the  "balance." 
From  this,  working  in  conjunction  with  the  price 
theory  already  evolved,  the  economists  deduced  the 
view  that  when  a  country  exported  hea\'ily,  money 
came  to  it  in  large  quantities,  and  as  a  result  commodi- 
ties tended  to  become  higher  in  price.  This  made  it  a 
less  desirable  country  in  which  to  buy  goods,  so  that 
there  was  an  automatic  check  upon  the  exportations, 
which  promptly  fell  off.  In  this  way  through  the  back- 
ward and  forward  movement  of  specie,  international 
supplies  of  metal  were  equalized  or  "adjusted"  to  the 
"volume  of  business"  developing  in  the  various 
countries. 

The  theory  began  to  assume  a  much  more  difficult 
aspect  when  the  definition  of  the  term  "money"  was 
broadened.  J.  S.  IVIill,  a  strong  adherent  of  the  quanti- 
tative theory  of  money,  defined  the  term  money  as 
meaning  volume  of  money,  a  term  which,  according  to 
him,  could  be  analyzed  into  two  factors  or  elements — 
(1)    the  quantity  of  money  in  existence  or  available 


486  BANKING  AND   BUSINESS 

and  (2)  the  rapidity  of  circulation.  This  thought  he 
expressed  in  the  well-known  formula  V=QxR.  Of 
course,  from  this  it  was  fairly  to  be  inferred  that  if 
methods  of  economizing  the  supply  of  money,  or  of 
making  it  more  efficient  in  circulation,  could  be  devised, 
the  tendency  would  be  to  raise  prices.  Conversely, 
of  course,  changes  in  method  which  rendered  money 
less  efficient,  as  well  as  withdrawals  for  the  purpose  of 
hoarding  or  uneconomic  bank  reserve  methods,  tended 
to  reduce  the  efficiency  of  money — that  is,  the  supply 
of  it  or  volume — and  so  tended  to  reduce  prices. 

A  further  complexity  came  into  the  theory  when  it 
was  admitted  that  there  were  other  factors  wliich 
tended  to  alter  the  relationship  between  money  and 
goods.  Evidently  if  all  conomodities  could  be  conceived 
as  to  be  divided  into  two  groups,  one  of  which  was 
actually  bought  and  sold  by  the  use  of  money,  while 
the  other  was  bought  and  sold  by  the  use  of  book 
credits  or  money  substitutes  of  some  kind,  it  was  a 
fair  question  whether  the  relation  of  money  to  goods 
had  not  been  seriously  altered.  Some  economists  de- 
veloped the  thought  that  in  these  circumstances  prices 
were  determined  in  that  range  of  trading  where  goods 
were  actually  exchanged  against  money  or  the  equiva- 
lent of  money,  while  other  goods  were  regarded  as 
outside  the  general  exchange  field.  Thus,  for  example, 
if  farmer  A  sold  eggs  to  the  local  dealer,  at  forty  cents 
per  dozen,  such  an  exchange  was  one  of  the  factors 
tending  to  fix  the  price  of  eggs;  but  if  farmer  A,  on 
reaching  the  store,  merely  looked  into  a  newspaper 
where  he  saw  eggs  quoted  at  forty  cents  and  then 
purchased  from  the  dealer  tea  or  cofTee  to  an  amount 
of  forty  cents,  there  was  a  kind  of  barter,  eggs  being 
really  exchanged  against  tea  or  coffee  on  a  basis  which 
had  been  detennined  in  that  range  of  trade  where  the 
goods    were    actually    sold    for    money.     Still    other 


PRICES,   MONEY,   AND   BANKING   487 

economists  favored  a  much  more  highly  refined  view 
of  the  situation  in  which  they  held  that  all  means  of 
exchange,  including  money  itself,  paper  currency, 
credit  media  of  various  kinds— in  short,  everything 
constituting  demand  for  goods  were  to  be  looked  upon 
as  making  up  the  demand  side  of  a  price  equation, 
while  all  goods  which  were  being  offered  for  sale, 
whether  actually  sold  for  money  or  not,  constituted 
the  supply  side.  The  price  level  was  determined  by  a 
balancing  of  money  against  goods,  and  the  question 
whether  an  actual  net  addition  to  the  amount  of  metal 
in  circulation  would  or  would  not  increase  the  level  of 
prices  depended  upon  whether  there  were  or  were  not 
offsetting  factors  that  came  into  play.  About  all  that 
could  be  definitely  said  of  this  theory  was  that  it  held 
that  additions  to  the  actual  supply  of  money  tended, 
"so  long  as  other  things  were  equal,"  to  raise  prices, 
while  a  subtraction  from  the  supply  of  money  tended 
to  reduce  them. 

V.  Banking  and  Paper  Money. 

In  any  of  these  views  of  the  price  situation  there  was 
clearly  an  important  pubhc  side  of  banking  not  or- 
dinarily thought  of  by  the  customer  or  patron  of  the 
bank,  and  which  consisted  in  the  furnishing  of  what  is 
ordinarily  called  "paper  money,"  also  usually  described 
as  "currency."  There  are  several  kinds  of  paper 
money  of  this  sort,  but  only  three  need  be  mentioned 
at  this  point.  One  is  the  so-called  irredeemable  paper 
currency'"  which  is  from  time  to  time  issued  by  govern- 
ments that  find  themselves  under  the  necessity  of 
quickly  getting  some  means  of  meeting  pressing  obliga- 
tions. The  well-known  greenbacks  issued  by  our  own 
government  during  the  Civil  War  afford  an  example 
of  such  currency.    These  were  irredeemable  for  about 


488  BANKING  AND   BUSINESS 

seventeen  years  after  they  were  first  issued  in  1862,  but 
later  the  government,  in  1879,  began  redeeming  them 
in  gold  and  has  continued  to  convert  them  either  into 
silver  or  gold  practically  at  the  will  of  the  holder  ever 
since. 

There  are  many  other  examples  of  irredeemable  paper 
currency  issued  in  different  countries  of  the  world 
which  might  be  cited  as  an  example,  but  there  would 
be  no  use  in  recapitulating  them  here.  It  is  enough  to 
say  that  such  notes,  when  issued,  are  merely  direct 
obligations  of  the  government  which  issues  them,  and 
that  they  have  no  relation  to  banking.  Indeed,  under 
such  circumstances  banks  usually  find  it  necessary  to 
receive  and  pay  out  such  notes  as  if  they  were  coin, 
holding  them  in  their  own  vaults  in  the  same  way. 
The  second  type  of  notes  or  currency  is  seen  in  our 
gold  and  silver  certificates.  These  are  merely  in  the 
nature  of  warehouse  receipts,  evidencing  the  possession 
by  the  holder  of  a  given  quantity  of  gold  or  silver  coin 
which  the  government  is  retaining  behind  them.  Gold 
certificates  are  now  legal  tender,  but  in  any  case 
they  merely  represent  a  claim  to  a  specified  amount 
of  coin  which  is  held  in  trust  behind  them.  The  notes 
issued  by  a  bank  are,  as  has  been  seen  in  an  earlier 
chapter,  an  entirely  different  kind  of  currency  because 
they  come  out  as  the  result  of  a  need  for  means  of 
transferring  goods,  and  are  thus  protected  by  the  obliga- 
tions of  business  men,  while  at  the  same  time  they 
are  limited  in  amount  because  they  are  presumably 
never  issued  without  having  a  full  backing  or  protection 
which  keeps  them  sound  and  safe  for  the  holder. 
Nevertheless,  the  fact  that  the  notes  themselves  are 
issued  and  are  used  by  the  public  means  that  a  corre- 
spondingly smaller  amount  of  coin  is  likely  to  be  called 
for  or  used  by  the  public.  This  is  why  the  bank  note 
is  ordinarily  spoken  of  as  a  ''substitute"  for  money. 


PRICES,   MONEY,  AND   BANKING   489 

It  is  a  supplement  to,  rather  than  a  substitute  for, 
money,  but  the  fact  remains  that  if  it  were  not  for  the 
bank  note  there  would  be  a  greater  need  for  other 
media  of  exchange,  so  that  in  a  certain  sense  the  bank 
note  has  a  monetary  function.  It  is  for  this  reason 
that  in  countries  which  have  carefully  regulated  bank- 
ing systems  special  effort  is  made  to  protect  the  notes 
in  an  adequate  way,  and  to  make  sure  that  innocent 
holders  are  subject  to  as  little  danger  as  possible. 
On  the  other  hand,  it  is  also  true  that  there  is  a  very 
general  effort  in  all  systems  of  legislation  to  make  sure 
that  bank  notes,  like  money,  are  receivable  every- 
where throughout  the  country  at  their  face  value  and 
without  any  charge  for  exchange. 

VI.  Banking  and  Prices. 

There  is  a  subtler  relationship  between  the  bank 
and  the  community  than  this  function  of  furnishing  a 
medium  of  exchange.  It,  however,  grows  out  of  the 
latter  phase  of  bank  activity.  If  a  bank  actually  puts 
out  something  which  is  used  instead  of  money,  and  if  it 
be  true  that  the  quantity  of  money  in  circulation  has 
an  influence  upon  the  rate  at  which  money  exchanges 
for  goods,  the  question  may  be  asked  whether  it  is  not 
true  that  the  bank  has  an  important  influence  in 
raising  or  lowering  prices.  Before  this  question  can 
be  answered  very  satisfactorily,  however,  it  is  necessary 
to  remind  the  reader  that  goods  are  exchanged  not  only 
through  the  use  of  money  or  bank  notes,  but  they  may 
also  be  exchanged  by  action  of  bank  customers  in 
drawing  checks  upon  deposits  which  have  been  credited 
to  them  upon  the  books  of  banks.  It  would  seem, 
then,  that  both  when  they  issue  notes  and  when  they 
create  deposits  on  their  books  the  banks  provide  a 
means  of  exchanging  goods,  and  so  tend  to  enable  the 


490  BANKING  AND   BUSINESS 

community  to  do  without  money,  and  that  they  thus 
influence  prices.  The  question  whether  banks  by 
furnishing  paper  currency  do  not  act  upon  prices 
should  thus  be  put  in  a  rather  different  way  by  in- 
quiring whether  banks  do  not,  as  a  matter  of  fact,  by 
extending  credit  in  either  form — notes  or  deposit  ac- 
counts— act  upon  prices.  As  to  this  there  can  be  no 
-question.  A\Tien  a  bank  gives  to  an  individual  funds 
in  the  form  of  notes  or  deposits  which  enable  him  to 
buy  more  freely,  it  enables  him  to  make  an  effective 
demand  for  commodities.  If  the  customer  makes  use 
of  this  demand  the  effect  is  to  raise  prices.  Conversely, 
by  withholding  credit  the  bank  tends  to  hinder  the 
\  customer  from  making  his  demand  effective,  and  so 
\  tends  to  prevent  prices  from  rising,  or  tends  to  lower 
them,  relatively  speaking. 

.  It  should  be  noted  in  this  connection  that  the  bank 
does  not  in  such  case  create  purchasing  power  or  make 
something  out  of  nothing.  It  simply  recognizes  the 
existence  of  value,  and  enables  that  value  to  become 
effective.  The  service  rendered  is  somewhat  Hke  that 
of  a  railway.  If  at  point  A  there  is  a  shortage  of  food 
while  at  B,  one  hundred  miles  distant,  there  is  more 
food  than  is  needed,  a  railway  Une  between  the  two 
places  will  enable  those  who  have  an  excess  of  supplies 
to  transfer  them  to  those  w^ho  need  them.  The  railway 
does  not  create  the  food,  but  it  merely  renders  ex- 
change more  quickly  possible  than  would  otherwise 
be  true.  In  a  certain  sense  it  may  be  said  that  the 
working  of  the  road  tends  to  lower  prices  in  the  town 
where  scarcity  exists  by  bringing  food  from  another 
point,  but  this,  of  course,  is  on  the  assumption  that  the 
food  exists  and  is  ready  to  be  shipped.  Bank  credit 
enables  commodities  of  one  kind  to  be  more  freely 
exchanged  for  others.  It  can  be  seen,  however,  that 
if  in  the  two  points  A  and  B  of  which  we  have  spoken 


PRICES,   MONEY,  AND  BANKING   491 

there  was  scarcity  of  certain  things  and  abundance  of 
certain  other  things,  the  railway  might  simply  permit 
shipments  in  one  direction  which  were  offset  by  ship- 
ments in  another,  with  the  result  that  some  prices 
would  be  higher  and  some  would  be  lower  in  A  than 
would  otherwise  have  been  the  case,  while  a  like 
situation  would  prevail  in  B.  The  railroad  in  this  case 
would  have  tended  to  bring  about  a  more  uniform 
level  of  prices  in  the  two  places  and  to  adjust  prices 
to  one  another  more  accurately  in  each  place.  This  is 
exactly  what  banking  does.  Its  effect,  in  other  words, 
is  to  raise  some  prices  and  lower  others,  and  so  to 
eliminate  fluctuations.  This  is  a  different  kind  of  in- 
fluence from  that  which  is  ordinarily  ascribed  to 
banking  in  its  monetary  relations,  but  it  is  a  highly 
important  service  and  one  whose  value  to  the  com- 
munity can  scarcely  be  overestimated. 

Banks,  however,  may  be  inefficiently  or  badly 
managed,  and  as  a  result  they  may  grant  credit  (notes 
or  deposits)  to  persons  who  are  not  entitled  to  them — 
that  is  to  say,  who  have  not  the  actual  value  which 
will  enable  them  to  settle  their  obligations.  On  the 
other  hand,  banks  may  give  immediate  purchasing 
power  (notes  or  deposits)  to  borrowers  who  are  solvent 
in  the  sense  that  they  have  wealth  which  will  eventually 
be  realized,  although  not  for  a  long  time.  In  this  case 
what  the  banks  do  is  to  give  persons  with  long-term 
wealth  a  chance  to  consume  immediately.  The  result 
is  to  disturb  prices  rather  than  to  average  them,  and 
this  is  what  takes  place  in  a  period  of  inflation.  Credit 
is  too  readily  granted  and  results  in  enabling  many 
persons  to  buy  and  consume  commodities  when  they 
are  not,  economically  speaking,  in  position  to  do  so. 
The  result  is  unduly  high  prices — usually  followed 
later  on  by  unduly  low  ones.  The  bank's  influence 
here    has    been    reversed — instead    of    averaging    or 


492  BANKING  AND   BUSINESS 

smoothing  out  price  levels  it  has  accentuated  their 
fluctuations.  A  situation  of  this  kind  is  often  spoken 
of  as  if  it  showed  that  the  explanation  of  the  influence 
of  bank  credit  upon  prices  already  given  were  in  some 
way  erroneous.  The  contrary,  however,  is  the  in- 
ference to  be  drawn  from  it.  Bank  credit  exerts  a 
certain  kind  of  influence  upon  prices,  but,  as  with 
every  force,  this  influence  may  be  used  to  lessen  dis- 
turbance or  to  increase  it.  The  theory  of  its  applica- 
tion, however,  is  the  same  in  either  case. 

VII.  Banking  and  Exchange. 

Whether  it  be  regarded  as  merely  rendering  money 
more  efficient,  enabling  a  unit  of  money  to  perform  a 
larger  number  of  exchanges,  or  as  permitting  exchanges 
to  take  place  without  the  use  of  money,  the  effect  is 
about  the  same — that  is  to  say,  banking  tends  to  create 
a  condition  of  exchange  in  which  it  is  easier  to  dispose 
of  goods,  or  in  which  goods  are  enabled  to  command 
the  widest  possible  market.  This  being  granted,  it  is 
clear  that  the  effect  of  banking  is  to  bring  about  an 
equalization  of  the  demand  for  and  supply  of  goods. 
Improvement  in  banking  methods  tends  to  render  this 
equalization  process  more  perfect,  and  thus  enables  the 
owner  of  goods  to  command  a  return  corresponding 
more  truly  to  the  real  exchange  value  of  his  product 
than  he  otherwise  could  get.  Of  course  the  reverse 
set  of  factors  would  tend  to  bring  about  the  reverse 
situation.  If  banking  credit  be  freely  extended  to 
borrowers  the  effect  of  it  is  that  of  rendering  the  bor- 
rowers' wealth,  whatever  it  might  be,  more  readily 
available  as  purchasing  power.  For  example,  if  A 
owned  1,000  kegs  of  nails,  it  might  be  quite  impossible 
for  him  to  exchange  even  a  small  part  of  them  for  food 
or  clothing  at  any  given  time.     He  could  do  so  only  if 


PRICES,   MONEY,  AND  BANKING  493 

he  found  an  immediate  demand  for  nails  either  in  his 
own  or  some  other  conmiunity  which  he  could  reach. 
If,  however,  he  could  convert  the  nails  into  credit  on 
the  books  of  a  bank,  the  bank  would  have  practically 
guaranteed  that  the  nails  would  have  a  certain  pur- 
chasing power  in  the  market,  the  understanding  being, 
of  course,  that  in  the  event  of  the  bank's  judgment 
proving  erroneous  the  borrower  would  make  up  the 
difference  out  of  other  wealth  of  which  he  might  stand 
possessed.  It  is  at  all  events  safe  to  say  that  the 
effect  of  banking  as  already  indicated  is  to  perfect 
exchange  and  hence  to  enable  commodities  to  gain 
their  widest  market. 

Just  here  the  question  arises  whether  the  analysis 
which  has  just  been  given  is  not  based  upon  the  as- 
sumption that  the  bank  can  always  recognize  value 
and  that  it  can  correctly  appraise  it.     The  answer,  of 
course,  must  be  in  the  negative.     Banks  are  not  always, 
even  with  the  best  application  of  judgment,  wise  in 
estimating  the  value  of  goods.     If  sugar,  say,  is  sold  at 
ten  cents  a  pound,  it  is  too  much  to  expect  the  bank 
to  be  able  to  predict  a  decline  in  the  price  of  such 
sugar  to,  say,  five  cents  per  pound.     If  the  bank,  how-    A 
ever,  converts  the  sugar  into  purchasing  power  at  the 
rate  of  ten  cents  per  pound,  giving  the  credit  on  its        , 
books,  it  has  enabled  the  owner  of  the  sugar  to  act  in       J 
the  market  as  if  he  had  definite  assurance  or  certainty       I 
that  the  sugar  would  be  worth  ten  cents  a  pound  up  to      I  ^ 

the  time  that  he  disposed  of  it.     WTien  banks  are  over- f"""^ 

confident  in  their  estimates  of  future  value  and  grant  to     I 
each  applicant  an  undue  proportion  of  credit  on  the     I 
strength  of  goods  offered  to  them  as  security,  or  when     I 
they  accept  goods  that  are  not  really  salable  as  the 
basis  for  such  advances,  they  place  in  the  hands  of 
the  borrowers  purchasing  power  which  the  latter  are 
not  entitled  to — that  is  to  say,  purchasing  power  which 


494  BANKING  AND  BUSINESS 

the  owners  of  the  goods  really  do  not  possess.  In  this 
case  the  borrowers  are  given  a  control  over  the  com- 
modities of  others  which  they  ought  not  to  have,  and 
if  they  exercise  or  apply  it  they  are  able  to  make  an 
artificial  demand  for  the  commodities  of  others. 
The  effect  of  such  action  on  their  part  is  to  raise  prices, 
and  the  resulting  condition  is  called  inflation.  With- 
drawal of  such  support  by  banks,  and  the  restoration 
of  the  price  level  to  the  point  it  would  have  occupied 
had  not  such  extensions  of  credit  been  made,  is  called 
deflation. 

The  bank  is  thus  seen  to  possess  a  very  broad  and 
far-reaching  power  over  prices  which,  although  self- 
corrective  in  the  long  run,  may  be  used  for  a  time  to 
distort  the  normal  price  level.  The  classical  theory 
of  banking  holds  to  the  view  that  this  danger  is  limited 
or  largely  avoided  if  banks  are  constantly  compelled 
to  redeem  their  outstanding  credits  in  money.  As 
prices  rise,  more  money  is  needed  for  circulation  in 
order  to  exchange  actual  goods.  This  tends  to  draw 
out  cash  from  the  vaults  of  the  banks,  and  their 
ratio  of  reserve  to  liabilities  becomes  smaller.  Thus 
the  banks  are  led  to  contract  their  Uabilities.  The 
safeguard  which  is  thus  supposed  to  exist  is,  however, 
temporarily  absent  if  redemption  is  suspended  or  if 
the  movement  of  specie  out  of  and  into  a  country  is 
checked  or  interfered  with.  It  is  entirely  lacking 
when  banks  are  relieved  of  the  necessity  of  redeeming 
their  obligations,  as  they  were  during  the  European 
War.  In  such  circumstances  the  automatic  relation- 
ship to  money  disappears  and  bank  credit  becomes  an 
independent  factor  in  the  price  equation. 

The  question  properly  to  be  asked  in  this  connection 
relates  to  the  standards  or  measures  which  banks  can 
or  should  apply  in  determining  whether  the  credit 
extensions  they  make  are  likely  to  have  the  moderating 


PRICES,   MONEY,   AND   BANKING   495 

influence  already  spoken  of  or  the  disturbing  influence. 
It  seems  to  be  assumed  by  some  writers  that  there  is  no 
definite  means  by  which  the  banker  can  assure  himself 
of  the  effect  of  the  credit  he  grants,  so  that  as  a  matter 
of  fact  he  can  never  be  certain  of  the  social  influence 
produced  by  his  work.  This  is  an  erroneous  view  of  the 
situation.  There  is  a  perfectly  safe  and  reliable  guide 
which  can  almost  invariably  be  applied  by  the  banker. 
If  the  credit  that  he  grants  is  for  a  period  not  longer 
on  the  average  than  the  period  of  commercial  credit 
in  his  community,  his  extension  of  credit  will  tend  to 
bring  about  a  steadier,  smoother  flow  of  goods  from 
producer  to  consumer,  and  so  will  tend  to  "even  up" 
prices.  If,  on  the  other  hand,  the  period  of  credit 
allowed  by  the  banker  is  much  longer  than  that  which 
is  necessary  to  bring  about  the  transfer  of  goods  from 
producer  to  consumer,  the  banker  is  practically  supply- 
ing the  producer  with  capital,  or  in  other  words  is 
enabling  him  to  keep  turning  over  his  operations.  In 
this  case  the  counter  effect  of  the  credit  already  spoken 
of  sets  in.  It  may  easily  be  that  in  any  given  loan  or 
at  any  given  moment  the  banker  may  find  it  difficult 
to  decide  whether  his  extension  of  credit  is  safe  or 
sound  or  not,  or  whether  it  is  being  used  to  bring  about 
fluctuations  of  prices.  An  analysis  of  the  general  port'- 
folio  or  body  of  investments  of  the  bank,  however, 
always  shows  the  real  character  of  the  a\Trage  credit 
extended  by  the  banker  and  gives  him  an  unquestion- 
able standard  of  judgment.  If  his  loans  are  con- 
stantly growing  longer,  being  renewed  and  seldom  com- 
pletely liquidated  or  cleaned  up  by  the  borrowers, 
the  banker  is  in  what  is  technically  called  an  "over- 
extended condition."  In  such  a  case  the  bank  is 
tending  to  accentuate  price  fluctuations. 

Recognition  of  this  important  function  on  the  part 
of  the  bank  has  led  in  some  quarters  to  a  demand  for 


490  BANKING  AND   BUSINESS 

government  regulation  of  banking,  or  to  complaints 
that  a  money  autocracy  or  money  trust  was  able  to 
control  the  business  of  the  public,  enhance  prices  (or 
reduce  them),  or  otherwise  work  against  the  public 
interest.  Whatever  might  be  the  abstract  possibility 
of  the  creation  of  such  a  "trust"  experience  shows  that 
it  cannot  carry  matters  as  it  chooses  for  more  than  a 
very  short  time,  and  that  mistakes  or  unwise  policies 
in  banking  simply  react  upon  the  banks  themselves. 
The  banks,  in  other  words,  are  not  the  proprietors  of 
"money,"  but  they  are  service  institutions  whose  func- 
tion it  is  to  exchange  goods.  They  prosper  as  their 
customers  prosper  and  suffer  as  the  latter  suffer. 
Governments  have  no  means  of  testing  credit  or  of 
ascertaining  whether  it  is  being  wisely  or  unwisely 
extended,  except  those  that  the  banks  themselves  have 
devised  and  furnished.  The  whole  history  of  money 
and  banking  is  adverse  to  government  interposition 
in  or  management  of  banking.  As  we  have  already 
seen,  most  modern  banking  systems  provide  for  some 
participation  or  oversight  by  the  government,  but  this 
is  rather  to  insure  fair  play,  avoid  possibihties  of 
favoritism,  guarantee  thorough  examination,  and  other- 
wise maintain  the  rules  of  the  game,  than  it  is  to 
furnish  standards  of  control  or  canons  of  banking  that 
are  better  or  fairer  than  those  developed  by  the  banking 
business  itself. 

VIII.  Theory  of  Prices. 

Question  is  often  raised  as  to  the  definitive  theory  of 
prices  as  generally  held  at  the  present  moment.  The 
subject  is  still  one  as  to  which  controversy  exists  among 
economists  and  theorists.  Without  attempting  to  go 
into  this  controversy  in  any  detailed  way  or  to  discuss 
the  more  difficult  points  of  abstract  theory,  ^ve  may 


PRICES,   MONEY,   AND   BANKING   497 

fairly  state  certain  points  bearing  upon  the  theory  of 
prices  which  can  be  regarded  as  of  general  acceptance. 

1.  Definition.  Price  is  the  monetary  expression  of 
the  value  of  commodities,  or,  in  other  words,  it  is  the 
value  of  commiodities  expressed  in  terms  of  money; 
it  is  the  ratio  between  commodities  and  money. 

2.  Prices  are  the  result  of  a  comparison  of  the  supply 
of  and  demand  for  goods  and  money;  they  rise  or  fall 
according  to  increase  or  decrease,  relatively  speaking, 
of  demand  or  supply  of  the  various  factors  entering  into 
the  comparison. 

3.  Money  constitutes  a  demand  for  goods.  An  in- 
crease in  the  actual  volume  of  money  in  existence, 
therefore,  tends  to  raise  prices  if  there  are  no  offsetting 
factors.  Conversely,  a  decrease  in  the  volume  of  money 
has  the  opposite  effect. 

4.  Goods  constitute  a  demand  for  money  or  for 
other  goods,  and  an  increase  in  them  tends  to  lower 
money  prices  accordingly. 

5.  Credits  on  the  books  of  banks — deposits — are 
theoretically  claims  to  money  and  they  may  be  regarded 
as  constituting  a  demand  for  commodities  in  the  same 
way  that  money  is  a  demand  for  commodities. 

6.  An  increase  in  the  total  outstanding  quantity  of 
bank  credit  is  thus  potentially  a  demand  for  commodi- 
ties which  may  tend  to  raise  the  price  of  commodities, 
but  only  if  it  is  used  in  actual  purchases. 

7.  In  the  same  way  a  decline  in  the  total  volume 
of  bank  credit  outstanding  may  tend  to  curtail  the 
amount  of  demand  for  commodities  and  may  thus  tend 
to  lower  prices. 

8.  The  ciucstion  whether  an  increase  in  the  volume 
of  money  or  bank  credits  will  or  will  not  affect  the 
prices  of  goods  depends  upon  several  factors  which 
influence  the  activity  of  money  and  credit  and  which 
determine  the  direction  in  which  the  purchasing  power 


498  BANKING  AND  BUSINESS 

shall  be  exerted.  It  is  not  true,  as  is  sometimes  sup- 
posed, that  the  purchasing  power  rendered  available 
by  a  bank  which  grants  deposit  credit  is  exerted  prac- 
tically equally  over  the  whole  field  of  business  or  goods. 
9.  At  any  given  mornent  the  analysis  of  causes  of 
price  changes  involves  a  considerable  number  of  factors 
any  one  of  which  may  have  become  more  or  less  im- 
portant during  the  immediately  preceding  period.  The 
analysis  or  statement  of  the  price  equation  at  any 
given  time  is  thus  tentative,  and  can  be  made  absolute 
only  in  given  cases  as  the  result  of  study  and  the 
eUmination  of  changing  factors. 


CHAPTER  XXIX 

ECONOMIC  SIGNIFICANCE  OF  BANKING 

I.  Permanence  of  Present  Form  of  Banking. 

A  review  of  the  present  practice  of  banking  and  the 
elements  of  financial  theory  upon  which  it  is  founded 
suggests  to  the  student  of  the  subject  certain  broader 
considerations  which  must  be  taken  into  account  in 
forming  a  general  conception  of  the  subject  and  in 
giving  it  its  proper  place  both  as  an  important,  not  to 
say  fundamental,  phase  of  modern  economic  organiza- 
tion, and  as  a  highly  developed  department  of  business 
life.  The  business  man  is  inclined  to  accept  existing 
institutions  for  what  they  are,  and  to  use  and  deal 
with  them  in  their  present  form  and  without  a  very 
critical  estimate  of  their  significance.  This  is  unavoid- 
able. Business  activity  is  immediate  and  practical 
and  is  concerned  with  the  attainment  of  results  rather 
than  with  the  alteration  or  reform  of  methods. 

Nevertheless,  it  is  true  that  business  life  is  pro- 
gressive and  that  all  economic  institutions  are  under- 
going a  process  of  steady  evolution  and  change.  The 
broad-minded  student  of  business,  and  equally  as  much 
so  the  broad-minded  participant  in  business,  vn\\ 
therefore  make  a  far  more  intelligent  and  effective  use 
of  the  institutions  ^^^th  which  he  comes  into  contact 
if  he  accustoms  himself  to  recognize  their  broad  social 
significance  and  their  place  in  the  economic  organiza- 
tion of  society. 

In  the  opening  chapters  of  the  present  volume  it  was 


500  BANKING  AND   BUSINESS 

explained  that  the  banking  and  credit  organization  of 
modern  business  is  practically  essential  to  the  mainte- 
nance of  the  principle  of  the  division  of  labor  and  to 
the  more  complete  and  full  development  of  such 
division.  This  may  perhaps  be  taken  as  unquestion- 
able; as  nothing  more  than  the  statement  of  a  more  or 
less  obvious  economic  fact.  From  it,  however,  certain 
inferences  must  be  drawn  and  upon  it  certain  conclu- 
sions must  rest. 

II.  Continuation  of  Division  of  Labor. 

The  first  question  which  suggests  itself  with  respect 
to  banking  in  its  present  form  is  probably  the  recur- 
rent question  which  is  always  asked  as  to  all  economic 
forms — how  far  is  it  permanent,  ard  how  far  is  it 
merely  a  transitional  stage  of  activity  which  will 
sooner  or  later  pass  into  another?  The  preliminary 
answer  to  this  question  is  afforded  when  we  inquire 
how  permanent  the  principle  of  di\dsion  of  labor  is 
likely  to  be.  If  it  be  assumed  that  large-scale  produc- 
tion is  a  desirable  feature  of  economic  organization 
and  that  the  development  of  skill  in  special  hnes  is  to 
be  encouraged,  the  conclusion  seems  almost  inevitable 
that  a  regime  of  continuously  greater  di\'ision  of  labor 
may  be  expected  to  go  on  indefinitely  developing. 
This  is  stated  vdih  full  consciousness  that  some  theo- 
rists beheve  that  such  division  of  labor  has  been  carried 
too  far  and  that  in  the  future  there  may  be  a  tendency 
toward  greater  individualization  of  production,  \\ath 
a  less  highly  interdependent  relationship  of  the  dif- 
ferent classes  of  society.  A  more  difficult  phase  of  the 
question  is  raised  when  it  is  inquired  whether  di\'ision 
of  labor  on  the  present  basis  is  to  be  regarded  as  largely 
an  outgrowth  of  what  is  called  capitalistic  enterprise, 
and  whether,  as  it  advances  in  the  scope  and  efficiency 


SIGNIFICANCE   OF   BANKING        501 

of  its  undertakings,  it  may  not  be  possible  gradually 
to  do  away  with  what  we  now  call  individual  o^^'ne^- 
ship  or  capitalist  production,  and  to  substitute  com- 
munity effort  or  production.  Such  a  discussion  in  its 
broad  terms  would  be  out  of  place  here;  and  it  is 
desired  only  to  draw  attention  to  the  relation  of  bank- 
ing to  this  phase  of  economic  inquiry.  There  have 
been  some  theorists,  especially  within  recent  years, 
who  have  not  hesitated  to  express  the  view  that  the 
use  of  money  and  credit  in  their  present  form  is  in- 
jurious, and  to  say  that  as  industry  is  socialized,  not 
only  money,  but  also  probably  banking  as  we  now 
know  it,  will  become  obsolete.  Apparently  the  basis 
of  such  ^'iews  is  found  in  the  thought  that  an  omnipo- 
tent state,  with  the  entire  resources  of  the  community 
in  its  control  and  with  unlimited  means  of  information 
open  to  it,  ^\^ll  be  able  to  assign  duties  artificially  to 
given  classes  or  individuals,  and  thereby  to  determine 
what  shall  and  what  shall  not  be  produced,  and  the 
proportions  in  which  goods  shall  exchange. 

III.  Future  Position  of  Banking. 

Supposing  that  such  a  development  were  possible, 
what  would  be  the  effect  of  it  upon  the  situation  of 
banking?  It  would  presumably  render  unnecessary 
the  present  arrangements  between  individuals  and  in- 
dustrial groups  which  are  undertaken  for  the  purpose 
of  carrying  on  production  by  the  use  of  credit,  and  of 
distributing  the  output  of  industry  to  the  various  con- 
sumers who  may  or  may  not  be  willing  to  absorb  it 
in  the  proportion  in  which  it  has  been  created.  The 
view  that  banking  in  the  abstract  is  not  a  necessary 
occupation,  but  is  one  of  those  "middleman  enter- 
prises" which  may  theoretically  be  dispensed  with, 
is  probably  as  tenable  as  any  other  of  the  elements  of 


502  BANKING  AND  BUSINESS 

the  theory  of  government  activity  or  interposition  in 
industry.  It  should  be  observed,  however,  that  the 
gradual  elimination  of  banking  as  an  element  in  eco- 
nomic organization  depends  upon  the  substitution  of 
something  else  which  will  take  its  place  and  will  per- 
form a  similar  service — always  assuming,  as  already 
stated,  the  existence  and  probable  increase  of  division 
of  labor.  That  something  which  must  thus  be  sup- 
plied is  clearly  an  ability  to  adjust  production  to  con- 
sumption, and  to  distribute  the  productive  forces  of 
society  among  the  objects  to  which  they  are  to  be  as- 
signed in  such  a  way  as  to  bring  about  an  even  balance. 
Reduction  of  the  importance  of  banking  will  be  de- 
ferred, therefore,  until  such  time  as  absolute  knowl- 
edge of  consumers'  tastes,  preferences,  and  disposition 
to  purchase  can  be  obtained,  and  until  some  overruling 
authority  is  able  to  force  industry  into  the  channels 
which  are  necessary  to  produce  commodities  in  these 
relative  proportions  and  to  keep  industrial  activity 
out  of  all  others.  That  this  is  a  state  of  things  which 
is  likely  to  be  so  long  deferred  that  it  may  be  expected 
from  the  human  standpoint  never  to  take  place, 
would  seem  to  be  an  accurate  conclusion,  and  accord- 
ingly the  inference  must  be  drawn  that  banking  is, 
in  the  ordinary  sense  of  the  term,  a  permanent  element 
or  factor  in  economic  life  as  we  know  it.  It  is  not 
likely  that  an  increase  of  state  activity  or  the  growth 
of  socialistic  practices  will  in  any  considerable  degree 
dispense  with  banking  as  a  means  to  the  proper  con- 
duct of  economic  activities  of  society.  Rather  is  it 
true  that  a  continued  evolution  of  the  state  and  an 
increase  of  its  functions  wdll  be  successful  about  in  the 
proportion  in  which  an  active  and  effective  credit  and 
banking  system  is  employed  for  the  purpose  of  guiding, 
directing,  and  determining  the  lines  along  which  such 
state  activity  can  well  be  directed.    The  probabiUty 


SIGNIFICANCE   OF   BANKING         503 

would  seem  to  be  that  banking,  far  from  declining  in 
importance  or  being  discarded,  will  become  a  more  and 
more  important  industrial  agency. 

IV.  Public  Service  Nature  of  Future  Banking. 

The  direction  of  its  development  is  not  toward 
atrophy,  but  is  rather  toward  expansion  along  new 
lines  and  with  new  purposes.  These  purposes  are 
essentially  those  of  public  service.  As  industrial  or- 
ganization becomes  more  complex  and  as  the  effect  of 
banking  upon  industry  and  prices  is  better  and  better 
recognized,  it  becomes  more  and  more  necessary  to 
provide  regular  access  to  credit  and  not  to  leave  such 
access  open  to  chance  or  casual  bargaining.  In  all 
institutions  which  have  been  developed  as  the  result  of 
modern  specialization  of  industry,  the  gradual  evolu- 
tion has  been  in  the  direction  of  a  recognition  of  pubUc- 
service  qualities.  Two  hundred  years  ago  even  ordi- 
nary roads  were  regarded  as  private  property  and  tolls 
were  charged  for  passage  over  them.  The  same  was 
true  of  bridges,  and  when  railroads  came  into  existence 
it  was  a  long  time  before  their  position  as  common 
carriers  was  recognized  and  rates  and  fares  reduced 
to  a  standard  basis,  while  the  duty  of  maintaining 
regular  service  was  insisted  upon.  In  the  same  way 
banking,  which  began  as  money  lending  and  whose 
service  as  well  as  the  charge  for  it  has  for  many  years 
been  the  subject  of  negotiation  and  bargaining,  is 
tending  more  and  more  to  assume  a  standardized  form. 
This  standardization  is  seen  to  best  advantage  in  the 
increasing  unity  and  similarity  of  commercial  banking 
requirements,  in  the  practical  identity  of  different  types 
of  paper,  and  in  many  other  ways.  It  appears  also 
in  the  constant  demand  that  provision  shall  be  made 
for  credit  for  the  moving  of  crops  and  for  all  sorts  of 


504  BANKING  AND   BUSINESS 

necessary  operations  which  shall  not  be  dependent 
upon  private  enterprise  or  activity,  but  shall  be  the 
result  of  community  action.  It  is  the  perception  of 
the  public-service  nature  of  banking,  no  doubt,  that  has 
led  some  nations  and  states  to  enter  the  business. 
The  belief  that  access  to  credit  has  been  cut  off  or 
unduly  restricted  by  combinations  of  capital  in  order 
to  drive  individuals  out  of  business  or  to  promote  the 
prosperity  of  others,  is  difficult  to  prove  in  any  par- 
ticular instance.  It  is  probably  seldom  attempted  in 
the  crude  forms  that  are  sometimes  referred  to  in 
current  prints.  Knowledge  of  economic  history,  how- 
ever, shows  how  transportation  was  used  for  competi- 
tive purposes,  and  there  is  no  reason  to  doubt  that  a 
similar  misuse  could  be  made  of  banking  and  credit. 
A  recognition,  therefore,  of  credit  facilities  as  practi- 
cally an  essential  necessity  of  business  leads  further  to  a 
recognition  of  full  pubhc-service  character,  and  hence 
to  the  safeguarding  of  conditions  under  which  banks 
operate  and  under  which  loans  may  be  granted. 

No  success  has  thus  far  been  had  either  in  regulating 
rates  of  interest  or  in  controlling  the  conditions  under 
which  loans  are  made  or  the  amount  of  accommodation 
to  be  extended  on  specified  security.  Public-owned 
banks  when  organized  have  been  unsuccessful  in  the 
majority  of  cases.  Better  success  has  been  had  with 
co-operative  banking  enterprises,  best  exempUfied  in 
various  rural  credit  undertakings,  but  even  these  have 
found  their  success  greatest  when  their  operations  were 
simplest  and  most  closely  standardized,  while  their 
success  has  been  least  in  those  cases  in  which  they  ven- 
tured into  complex  transactions  which  were  not  under- 
stood by  their  constituents  and  in  which  the  pressure  to 
attempt  difficult  or  impossible  operations  was  too  great 
to  be  resisted.  Public  management  of  banking,  or  even 
the  application  of  absolutely  rigid  requirements  to  it 


SIGNIFICANCE  OF  BANKING       505 

in  the  sense  in  which  such  requirements  are  apphed 
to  transportation  companies,  is  certainly  a  long  way 
in  the  future. 


V.  Recognition    of    Public    Service    Nature    of 
Banking. 

Meantime,  however,  progress  toward  a  condition 
which  may  render  unnecessary  further  intervention  on 
the  part  of  the  government  is  rapid.  The  best  bankers 
are  more  and  more  recognizing  that  in  addition  to  their 
duty  to  stockholders  and  to  depositors  they  also  owe 
a  general  duty  to  the  community,  since  the  maintenance 
of  solvency  and  convertibihty  has  been  intrusted  to 
them,  and  since  they  therefore  are  in  charge  in  a  peculiar 
sense  of  the  regulating  economic  mechanism  of  society. 
Gradually  the  tendency  among  the  ablest  and  best  men 
in  banking  is  toward  the  granting  of  crecht  as  a  matter 
of  routine  upon  the  presentation  of  specific  kinds  of 
security  or  the  establishment  of  a  certain  level  of  oper- 
ations, as  shown  by  a  suitable  statement,  and  the 
abandonment  of  the  type  of  operation  in  which  credit  was 
granted  merely  because  of  personal  considerations.  It 
still  remains  true  that  a  certain  class  of  bankers  are  in 
the  habit  of  talking  vaguely  about  the  importance  of 
"character"  as  a  basis  for  borrowing  and  its  superiority 
to  collateral  as  a  protection  for  loans.  In  this,  as  in  all 
such  expressions,  there  is  a  substratum  of  truth.  No 
banker  wants  to  make  loans  to  a  borrower  who  he 
knows  is  dishonest,  no  matter  how  valuable  the  col- 
lateral offered. 

On  the  other  hand,  no  banker  has  the  right  to  lend 
funds  intrusted  to  his  charge  to  a  customer  of  "char- 
acter" but  who  has  no  definite  protection  for  the  funds 
or  wishes  to  apply  them  in  speculation.  Banking  is 
essentially  a  fiduciary  occupation,  and  as  this  is  more 


50G  BANKING  AND  BUSINESS 

and  more  recognized  the  basis  of  credit  comes  to  be 
better  and  better  established  and  the  extension  of 
credit  less  and  less  a  matter  of  favor  or  "character," 
and  more  and  more  a  matter  of  routine.  This  is  as  it 
should  be,  and  eventually  it  may  be  expected  that 
credit  will  be  a  purely  scientific  study,  and  its  extension 
— the  "lending  of  money" — will  be  a  routine  process 
dependent  entirely  upon  submission  of  proper  evidence 
of  owTiership  or  value  or  of  a  definite  volume  of  business, 
by  the  applicant  for  credit.  The  cliques  and  groups 
which  in  isolated  cases  now  "manage"  banks  in  their 
own  interest  and  divert  the  funds  hither  and  thither 
for  the  promotion  of  their  own  enterprises  will  gradu- 
ally be  discredited  or  driven  from  business  through  the 
tightening  of  legislative  requirements,  and  perhaps 
through  the  direct  intervention  of  the  government. 

Probably  governmental  supervision  and  control  of 
transportation  would  never  have  gone  so  fast  or  so  far 
as  it  has  gone  had  transportation  managers  been  ready 
to  undertake  their  responsibility  as  public  servants. 
Much  the  same  may  be  said  of  banking.  In  the  case 
of  banking,  however,  there  is  a  much  broader  pos- 
sibility of  competition  and  self-protection  than  could 
ever  be  true  in  transportation,  especially  in  those 
countries  where  free  banking  has  taken  definite  root. 
Nevertheless,  the  struggle  of  the  future  in  connection 
with  banking  will  aim  to  secure  gradual  enforcement 
of  the  idea  of  the  pubUc  quahty  of  the  profession  and 
the  elimination  of  those  transactions  and  deaUngs 
which  have  heretofore  been  possible  by  reason  of  the 
low  conception  of  banking  and  the  improper  use  of 
funds  of  the  public  placed  in  the  hands  of  boards  of 
directors.  Banking,  in  short,  during  the  next  quarter 
century  mil  pass  through  a  period  of  discussion  and 
controversy  designed  to  determine  how  far  pubUc 
intervention  shall  go  in  the  management  of  the  busi- 


SIGNIFICANCE   OF   BANKING       507 

ness,  and  the  progress  of  such  pubhc  intervention  will 
depend  entirely  upon  the  progressive  capacity  of 
bankers  themselves.  As  already  stated,  a  hopeful 
sign  of  the  times  is  that  so  widespread  and  general  a 
perception  of  this  situation  exists  among  financiers 
and  that  there  is  so  large  a  percentage  of  them  who 
stand  ready  to  accept  their  full  duty  to  the  community. 

VI.  Adjustment  of  Relations  Between  Industry 
AND  Banking. 

In  one  way  or  another  banking  will  undoubtedly 
become  a  larger  and  larger,  as  well  as  a  more  usually 
employed,  mechanism  in  connection  with  business,  and 
from  the  practical  standpoint  the  problem  of  its  devel- 
opment will  be  that  of  adapting  it  to  different  phases 
of  economic  acti\ity  and  in  such  a  way  as  to  fit  these 
activities  in  with  the  general  scheme  of  things  so  as  to 
produce  a  harmonious  development.  By  way  of  illus- 
tration we  may  take  the  case  of  the  farmer,  who  for 
many  years  past  has  been  so  extensively  regarded  as 
the  special  beneficiary  of  the  nation.  In  the  case  of 
the  farmer  the  problem  of  credit  is  first  of  all  the  same 
as  that  of  any  other  producer — to  supply  him  with 
that  amount  of  credit  he  legitimately  needs  in  the 
conduct  of  his  business.  Secondly,  the  farmer's  credit 
problem  includes  the  provision  of  proper  means  for  hold- 
ing and  marketing  the  crop  over  a  reasonable  period. 
Thirdly,  the  farmer  is  also  a  consumer,  and  a  proper 
credit  system  for  him  includes  definite  provision  for  a 
reasonable  length  of  time  in  financing  his  purchases, 
pending  the  acquirement  of  income  sufficient  to  pay  for 
them — in  those  cases,  of  course,  where  they  repre- 
sent a  productive  investment,  as  \vith  seed,  farm 
machinery,  etc. 

We  now  have  in  many  countries  a  more  or  less 


508  BANKING   AND   BUSINESS 

adequate  means  of  providing  long-term  credit  for  the 
farmer  as  a  purchaser  of  land.  In  most  countries  we 
lack  adequate  farm  marketing  credit.  This  is  now  in 
process  of  development  in  the  United  States  as  well 
as  elsewhere,  and  it  may  be  expected  that  within  a 
reasonable  term  of  years  due  provision  will  be  made 
for  enabling  the  farmer  to  dispose  of  his  crops  steadily 
and  regularly  without  the  necessity  of  sacrifice  sales 
or  undue  losses  resulting  from  a  narrow  market  or  the 
disposal  of  the  product  to  a  single  man.  As  this  sys- 
tem of  rural  credit  is  developed  it  will  be  adapted  to 
the  general  commercial  banking  system  in  such  a  way 
as  to  peraiit  it  to  draw  fully  and  fairly  upon  the  general 
pool  of  resources,  but  at  the  same  time  to  avoid  draw- 
ing off  more  than  the  proportionate  share  of  fluid 
funds  to  which  the  producer  of  agricultural  goods  is 
entitled.  There  are  similar  problems  of  banking  and 
credit  to  be  developed  in  nearly  all  industries.  In  the 
past  the  practice  of  regarding  the  banking  system  as 
''sound"  when  it  had  assumed  a  stereotyped  form,  and 
of  denouncing  it  if  it  refused  to  lend  upon  any  security 
except  that  of  classical  or  conventional  type,  has  been 
too  prevalent.  The  future  development  of  banking 
will  provide  largely  for  the  working  out  of  banking 
principles  in  connection  wdth  different  branches  of  in- 
dustry, and  the  adjustment  of  the  institutions  which 
embody  or  apply  these  principles  to  the  combined 
banking  mechanism  of  the  community  as  a  whole. 
This,  in  short,  will  be  the  important  function  of  bank- 
ing in  modern  economic  hfe — the  general  facilitation 
of  trade  and  exchange;  and  this  will  be  the  course  of 
development  of  banking — the  adaptation  of  banking 
and  credit  principles  to  the  special  conditions  or  de- 
mands of  different  types  of  industry  in  such  a  way  as  to 
apportion  to  each  its  due  share  of  the  fluid  resources  of 
society  as  determined  by  demand  and  supply. 


SIGNIFICANCE  OF  BANKING       509 

VII.  Future  Development  of  Banking. 

In  this  aspect  the  future  development  of  banking 
opens  a  broad  field  to  the  constructive  and  ingenious 
man.  It  calls  for  the  working  out  and  application  of 
well-tried  principles  in  an  innnense  variety  of  fields. 
It  should  be  added,  however,  that  as  time  goes  on  and 
as  banking  accommodation  becomes  better  and  better 
recognized  as  a  necessity,  there  is  a  tendency  for  larger 
enterprises  to  develop  their  own  special  organizations 
to  deal  with  it.  Time  was,  as  already  often  stated, 
when  the  business  house  depended  almost  entirely  upon 
the  advice  of  the  banker.  He  was  a  guide  and  philoso- 
pher and  too  frequently  a  friend  to  the  business  man, 
expanding  or  contracting  the  credit  of  the  latter  as 
circumstances  required.  This  function  of  all  knowledge 
could  be  exercised  only  so  long  as  the  industry  was  in  a 
very  simple  condition.  It  is  out  of  the  question  to-day 
for  the  banker,  however  skilled  he  may  be,  to  know 
very  much  about  more  than,  at  most,  few  branches  of 
business.  In  the  great  banks  a  very  high  degree  of 
specialization  is  attempted,  and  given  officers  are  re- 
quired to  famiharize  themselves  ^\'ith  the  problems  of 
particular  kinds  of  industry.  As  they  become  highly 
special  in  their  knowledge  they  tend  to  drift  into 
the  branches  of  business  with  which  they  have 
become  best  acquainted,  or  the  managere  of  those 
branches  of  business  tend  to  associate  with  them- 
selves ex-bankers  or  financial  officers  familiar  with 
banking  whose  function  it  is  to  look  after  their 
financial  affairs.  Thus  in  many  cases  the  great 
business  concern  finds  it  worth  while  to  develop  a 
financial  department  of  its  o^vn  whose  function  is  that 
of  determining  its  borrowing  policy,  the  foiTn  of  its 
borrowings,  conditions  under  which  its  credit  is  granted, 
its  foreign-exchange  commitments,   and  a  variety  of 


610  BANKING  AND   BUSINESS 

other  matters.  The  importance  of  such  financial  de- 
partments of  corporations  is  seen  as  the  corporation 
itself  increases  in  scope.  In  the  case  of  some  corpora- 
tions it  has  even  been  thought  well  to  develop  its 
financial  department  actually  as  a  bank  or  as  some- 
thing corresponding  closely  to  a  bank.  This  tendency 
would  have  gone  farther,  it  is  likely,  had  it  not  been  for 
the  complex  relationships  to  either  individuals  or  busi- 
nesses which  are  assumed  when  a  bank  begins  to  take 
deposits.  Therefore  the  corporation  whose  financial 
department  has  assumed  an  extensive  and  complex  form 
finds  it  more  expedient  to  organize  a  separate  concern, 
which  is  sometimes  a  bank,  but  frequently  a  financing 
corporation  charged  with  the  duty  of  conducting  cer- 
tain operations,  largely  in  the  interests  of  the  parent 
company  which  brought  it  into  existence.  But  it  -udll 
probably  be  increasingly  true  that  every  corporation 
will  develop  a  financial  branch  or  division  whose  duty 
it  is  to  study  credit  and  to  manage  the  finances  of  the 
enterprise  in  the  most  economical  manner.  The  effect 
of  such  development  is  undoubtedly  that  of  reheving 
regular  banks  of  onerous  duties  and  responsibilities 
which  they  may  not  be  particularly  well  qualified 
to  perform,  and  thus  of  simplifying  their  relation- 
ship to  industry.  Just  as  many  great  enterprises 
develop  self-insurance  and  no  longer  rely  on  insurance 
companies,  so  many  other  enterprises  will  undoubtedly 
develop  self-banking  and  will  rely  on  banks  only  to 
supply  the  broader  and  more  general  features  of  their 
needs.  This  does  not  diminish  the  importance  and 
significance  of  banking,  but,  on  the  contrary,  it  en- 
hances it.  It  suggests  that  whereas  we  may  expect 
a  very  great  increase  in  the  number  of  banking  offices 
and  a  very  great  diversification  of  the  types  of  banking, 
we  may  also  expect  an  indi\'idualization  of  banking, 
with  the  performance  of  banking  functions  by  those 


SIGNIFICANCE   OF  BANKING       511 

corporations  with  a  sufficient  scope  of  business  to  war- 
rant them  in  doing  so.  The  assumption  of  these  bank- 
ing functions  will,  however,  as  already  noted,  be  in 
most  cases  simply  applicable  to  the  immediate  financial 
needs  of  the  concern  itself  and  will  not  result  in  the 
taking  over  of  duties  which  involve  the  supply  of 
credit  to  the  public.  But  the  development  of  these 
individualized  banking  functions  opens  a  large  field 
of  acti\aty  to  those  who  are  well  equipped  and  expert 
in  financial  matters  and  offers  a  great  and  important 
career  entirely  outside  of  the  field  of  banking  in  the 
narrower  sense  of  the  term. 


APPENDICES 


I 

DEFINITIONS  OF  CREDIT 
Adapted  from  J.  L.  Laughlin,  Principles  of  Money,  pp.  72-73. 

(See  text,  p.  11) 

1.  Knies:  "Exchange  in  which  one  party  renders 
a  service  in  the  present,  while  the  return  made  by  the 
other  falls  in  the  future." 

2.  Nasse:  ''Credit  is  the  confidence  felt  in  the  future 
solvency  of  a  person,  which  enables  him  to  obtain  the 
property  of  others  for  use  as  a  loan,  or  for  consumption." 

3.  Jevons:  ''Nothing  but  the  deferring  of  a  pay- 
ment." 

4.  Levasseur:  "The  exchange  of  an  actual  reality 
against  a  future  probability." 

5.  Wagner:  "Credit  is  that  private  economic  ex- 
change, or  that  voluntary  giving  and  receiving  of  eco- 
nomic goods  between  different  persons,  where  the 
service  rendered  by  the  first  is  performed  from  his  con- 
fidence in  the  assurance  given  by  the  second  that  he 
will  render  a  recompense  at  a  future  time." 

6.  McLeod:  "A  credit  is  the  present  right  to  a 
future  payment." 

7.  Leroy-Beaulieu :  "Credit  is  the  exchange  of  an 
actual  present  good  against  an  equivalent  which  one 
engages  to  furnish  within  a  certain  period." 

8.  Ferraris :  "The  whole  of  those  economic  and  moral 
conditions  because  of  which  men  consent  to  make  pay- 
ments in  the  present  on  the  promise  of  repayment  in 
the  future." 


516  BANKING  AND  BUSINESS 

9.Walras:   "Credit  is  the  lending  of  capital." 
l(k  Philippovich :  "Through  which  the  one,  by  virtue 
of  a  service  already  performed  (a  transfer  of  goods,  a 
payment,  or  work  done),  may  demand  from  the  other 
a  return  for  the  service." 


II 

OPERATIONS  OF  COMMERCIAL  BANKS 

Adapted  from  article  by  H.  G.  Moulton  on  "Commercial  Banking 
and  Capital  Formation,"  in  Journal  of  Political  Economy,  vol.  xxvi,  1918, 
pp.  490-494. 

(See  text,  pp.  21-23) 

Gilbart:  ** Providing  safety-deposit  vaults;  paying 
interest  on  deposits;  making  loans;  exchanging  funds 
between  places;  changing  currency  denominations; 
collecting  notes  and  drafts,  etc.";  he  also  adds  that  in 
connection  with  the  receipt  of  deposits  and  the  making 
of  loans  bankers  gather  together  money  in  small  sums 
and  transfer  it  in  larger  amounts  to  borrowers  engaged 
in  "trade  and  commerce."^ 

Dunbar:  ''The  bankers  created  no  new  wealth  by 
their  lending  and  deposit  holding,  but  .  .  .  they  di- 
rected the  existing  capital  to  the  enterprises  and  indus- 
tries most  in  need  of  support,  and  they  quickened  the 
succession  of  commercial  and  industrial  operations.  A 
given  amount  of  capital  was  thus  made  more  effective, 
so  that  the  result  of  the  introduction  of  banking  in  any 
community  was  the  equivalent  of  a  considerable  in- 
crease in  capital,  although  not  implying  any  real 
increase  in  the  first  instance."'^ 

White:  A  bank  is  termed  "a  manufactory  of  credit 
and  a  machine  for  facilitating  exchanges  " ;  discounting 
is  "the  swapping  of  well-known  credit  for  less-known 


'  Gilbart,  The  History,  Principlea,  and  Practice  of  Banking  (Michie's 
revision),  pp.  213-22. 

*  Dunbar,  Theory  and  History  of  Banking,  chap.  ii. 


518  BANKING  AND  BUSINESS 

credit";  the  banker  ''enables  the  most  deserving  per- 
sons in  the  community  to  get  capital"  and  thus  "per- 
forms a  service  to  society  by  economizing  tools  and 
materials."^ 

Holdsworth:  Commercial  banks  "receive  deposits  of 
cash,  checks,  and  drafts,  and  make  loans  to  the  business 
public  by  discounting  or  purchasing  commercial  paper. 
To  these  functions  may  be  added  a  third,  that  of  pro- 
viding a  medium  of  exchange  through  the  issue  of  cir- 
culating notes."  Various  incidental  services  are  also 
listed,  and  he  adds  that  a  bank  is  a  manufactory  of 
credit.  "Business  credit  cannot  be  conveniently  used 
for  current  business  transactions,  but  bank  credit  in 
the  form  of  checks  and  drafts  is  widely  acceptable."  ^ 

Scott:  "Customers  of  a  commercial  bank  sell  to  it 
their  surplus  cash  and  credit  instruments  representing 
pa5Tiients  due  them  from  other  persons,  and  make 
loans  from  it  secured  by  their  personal  notes  due  in 
the  future.  For  the  amounts  due  them  as  a  result  of 
these  transactions  they  are  credited  on  the  books  of 
the  bank  in  a  form  known  as  deposits.  .  .  .  Making 
loans  and  discounts  is  a  function  correlative  with  that 
of  conducting  deposit  accounts.  It  may  be  described  as 
the  process  of  advancing  funds  on  the  security  of 
personal  notes  and  bills  of  exchange  .  .  .  and  on 
collateral."^ 

Laughlin:  "The  business  of  the  bank  consists  of 
dealing  in  the  commercial  paper  which  grows  out  of 
current  transactions.  When  a  man  desires  funds  for  a 
long  period,  he  should  get  them,  not  from  the  bank, 
but  from  those  who  have  spare  capital  to  invest  for 
some  considerable  period  of  time.  The  bulk  of  banking 
business  .  .  .  consists  of  instruments  evidencing  claims 


1  White,  Money  and  Banking  (3d  ed.),  P-  193. 

2  Holdsworth,  Money  and  Banking,  pp.  148-49. 

^  Scott,  Money  and  Banking  (revised  edition),  pp.  108,  109. 


APPENDIX  519 

upon  individuals,  stated  in  terms  of  money,  and  result- 
ing from  operations  requiring  a  comparatively  short 
period  for  their  consummation."^ 

Johnson:  " The  principal  functions  of  the  bank  are 
the  collection  of  funds  of  loanable  capital  that  are 
available  for  short  periods  only,  and  the  em.ployment 
of  such  funds  in  call  and  short-term  loans."- 

Ely:  ''Having  converted  his  personal  credit  into  a 
bank  deposit,  the  business  man  can  now  use  it  as  a 
means  of  payment.  .  .  .  Ordinary  commercial  banking 
consists,  in  large  part,  of  this  purchase  of  personal 
credit  and  sale  of  banking  credit."^ 

Fisher:  ''Through  banking  he  who  possesses  wealth 
difficult  to  exchange  can  create  a  circulating  medium 
based  upon  that  wealth.  ...  To  put  it  crudely,  deposit 
banking  is  a  device  for  coining  into  dollars  land,  stores, 
and  other  wealth  not  otherwise  generally  exchangeable. 
Something  of  equivalent  value  is  behind  each  loan,  but 
not  necessarily  money.  The  note  (or  deposit)  holder's 
promise  (his  promissory  note)  is  secured  by  his  assets; 
and  the  bank's  promise  (the  bank  note)  is  secured  by 
the  bank's  assets.  The  noteholder  has  'swapped'  less- 
known  credit  for  better-known  credit."^ 

Fetter:  "The  essential  feature  of  a  bank  is  the  lend- 
ing of  its  credit.  .  .  .  The  process  of  lending  credit  is 
called  'deposit  and  discount.'  .  .  .  The  bank  is  a  tool 
performing  services  similar  to  those  of  money.  .  .  .  The 
gathering  of  loanable  funds  by  the  banks,  making  them 
available  at  once,  reduces  hoarding,  makes  money  move 
more  rapidly,  and  creates  a  central  market  between 
borrowers  and  lenders  for  the  sale  of  credit.  While  not 
creating  more  ph^'sical  wealth  directly,  it  adds  to  the 


•  Laughlin,  Banking  Reform,  p.  76. 

^  Johnson,  Introduction  to  Economics,  p.  286. 

^  Ely,  Outlines  of  Economics  (revised  and  enlarged  edition),  p.  247. 

*  Fisher,  Elementary  Principles  of  Economics,  pp.  109,  171,  173. 
34 


520  BANKING  AND  BUSINESS 

efficiency  of  wealth ;  it  oils  the  bearings  of  the  industrial 
machine."^ 

Taussig:  "Banks  perform  two  functions,  equally 
important,  yet  different.  They  act  as  agencies  for  the 
collection  of  savings  and  for  investment;  they  create  a 
part  of  the  medium  of  exchange.  ...  A  savings  bank 
has  to  do  with  investment  only.  ...  A  strictly  com- 
mercial bank  is  not  concerned  with  the  sort  of  invest- 
ment to  which  the  term  is  commonly  limited,  that  which 
looks  to  the  creation  of  permanent  plant.  But  such  a 
bank  suppHes,  in  English-speaking  communities  espe- 
cially, a  highly  important  part  of  the  circulating 
medium."  2 


^  Fetter,  Principles  of  Economics,  pp.  462.  464,  465. 
'^  Taussig,  Prindples  of  Economics,  i,  331. 


Ill 

COMMERCIAL  AND  INVESTMENT  BANKING 
Adapted  from  W.  H.  Steiner,  Some  Aspects  of  Banking  Theory. 

(See  text,  pp.  26-27) 

There  is  a  pool  of  commercial  financing  through 
which  effective  utihzation  of  the  social  circulating 
capital  is  rendered  possible.  The  individual  business 
enterprise  contributes  its  surplus  and  obtains  its 
deficit,  the  co-operative  application  of  the  capital  being 
effected  through  the  institution  of  commercial  banking. 
There  is  an  investment  pool,  as  well,  in  which  the  insti- 
tution of  investment  banking  partly  effects  the  co- 
operative appUcation  of  the  capital  which  is  contained 
in  that  pool.  Considerable  difference,  however,  exists 
between  the  two  pools.  The  pool  of  commercial  financ- 
ing concerns  itself  exclusively  ^ith  the  social  circulating 
capital,  while  the  pool  of  investment  financing  is  much 
wider,  and  concerns  itself  with  the  total  capital  in 
existence  and  includes  fixed,  as  well  as  circulating, 
capital.  In  a  broad  sense,  there  is  thus  included  in 
the  pool  of  investment  financing  the  capital  which  is 
contained  in  the  pool  of  commercial  financing. 

This  difference  in  area  goes  hand  in  hand  with  a 
difference  in  the  units  between  which  co-operation  is 
effected.  In  the  case  of  commercial  financing,  we  stop 
with  the  individual  enterprise ;  in  the  case  of  investment 
financing,  we  end  with  the  individual  himself.  In  the 
first  case,  the  lenders  and  borrowers  are  in  a  broad 
sense  one  and  the  same  class ;  in  the  other,  the  individ- 


522  BANKING  AND   BUSINESS 

ual  is  the  lending  unit,  while  the  business  enterprise 
is  the  borrowing  unit.  The  underlying  purposes  of  the 
two  pools  thus  differ.  The  commercial  pool  represents 
co-operation  by  business  enterprises  in  the  employ- 
ment of  the  circulating  capital  owned  by  these  enter- 
prises; the  investment  pool  represents  co-operation  by 
individuals  to  render  available  for  employment  by 
business  enterprises  the  capital  owned  by  these  in- 
dividuals. In  the  investment  pool,  relative  per- 
manency is  the  keynote,  both  on  the  part  of  borrower 
and  lender.  There  is  not  the  periodic  Uquidity  of 
funds  which  is  found  in  the  commercial  pool,  nor  is 
there  the  frequent  periodic  availability  and  inavail- 
abihty  of  funds — alternating  periods  of  surplus  and 
deficit — on  the  part  of  the  individual  enterprise.  The 
flow  of  capital  in  the  investment  pool  is  more  viscous. 
Slower  change  occurs  in  the  alignment  of  recipients  and 
of  lenders,  as  well  as  in  the  general  character  of  the 
investments  represented.  Change  in  the  investments 
occurs  primarily  in  the  direction  in  which  new  saved 
capital  is  applied. 

Corresponding  to  the  difference  in  the  fundamental 
purpose  of  the  two  pools  is  a  difference  in  the  technic 
by  means  of  which  the  pooling  is  effected.  The  factors 
in  the  investment  pool  are  more  diverse,  the  structural 
differentiation  is  more  pronounced,  and  the  relative 
importance  of  the  role  which  each  of  the  factors  plays, 
differs.  In  the  commercial  pool  the  structural  ele- 
ments are  threefold:  (1)  the  note  broker,  the  discount 
corporation,  and  the  finance  corporation;  (2)  the  com- 
mercial bank;  and  (3)  the  individual  enterprise  which 
either  sells  on  time  or  which  purchases  and  holds  com- 
mercial paper  with  its  surplus  fmids.  The  parallel 
elements  in  the  investment  pool  are:  (1)  the  trader 
in  securities,  such  as  the  bond  house  (including  also  the 
corporation  which  resells  securities  with  its  own    in- 


APPENDIX  523 

dorsement  or  issues  its  cwn  obligations  based  on 
these  other  securities);  (2)  the  association  of  lenders, 
in  the  form  either  of  savings  bank,  holders  of  time 
deposits  or  inactive  accounts  in  a  so  called  "com- 
mercial" bank,  insurance  company  conducted  upon 
the  actuarial  principle  of  reserves  as  distinguished  from 
the  actuarial  principle  of  distribution  of  loss,  or  co- 
operative bank;  and  (3)  the  individual. 

Concentrating  attention  upon  the  second  element,  it 
is  seen  that  while  banking  in  both  pools  concerns  itself 
with  the  assembhng  of  capital,  only  in  the  commercial 
sphere  does  it  concern  itself  equally  with  its  distribu- 
tion. Owing  to  the  character  of  the  purposes  to 
which  commercial  loans  are  applied,  and  the  corre- 
sponding duration  of  the  loan,  it  is  possible  to  change 
the  total  volume  of  loans.  On  the  other  hand,  by 
means  of  the  association  of  lenders — depositors,  the 
withdrawal  of  certain  enterprises  from  the  circle  of 
lenders — depositors  is  compensated,  broadly  speaking, 
by  the  adv^ent  of  others.  Thus  its  funds  again  become 
available  automatically  to  the  individual  lending  en- 
terprise through  the  commercial  banking  system.  In 
the  investment  sphere,  however,  this  availabiUty  is 
attained  in  another  manner.  Whereas  in  the  commer- 
cial pool  the  discount  market  is  primarily  a  question 
of  the  internal  organization  of  the  banking  system, 
in  the  investment  pool  the  security  market  plays  a 
far  wider  role.  In  the  investment  pool  the  individual 
investor  bulks  large  among  the  sources  of  capital  sup- 
ply. In  general,  he  holds  title  to  a  specific  security 
rather  than  what  is  in  effect  a  claim  to  a  proportionate 
share  of  the  total  holdings  of  a  group.  For  him,  sliift 
of  his  investment  is  accompUshed  only  through  sale 
to  another  individual  or  to  an  association.  Moreover, 
in  case  the  depositors  of  the  bank  call  upon  it  for  funds, 
in  the  absence  of  the  self-Hquidating  feature  in  its 


524  BANKING  AND   BUSINESS 

loans  and  investments,  it  must  have  recourse  to  the 
security  market.  Thus  a  broad  open  market  is  in- 
dispensable, and  it  is  in  this  connection  that  security 
speculation  performs  its  first  function. 

Considering  merely  the  investment  pool,  the  forms 
which  the  ''investment"  of  capital  assumes  therein 
are  threefold:  (1)  ownership  of  securities;  (2)  loans 
on  securities,  made  largely  either  to  bond  house  or 
speculator;  and  (3)  direct  loans  to  the  individual 
enterprise.  The  first  of  these  calls  for  no  special 
comment.  In  connection  with  the  second,  invest- 
ment banking  assists  in  directing  the  flow  of  capital 
into  investment.  This  it  does  through  loans  to  bond 
houses,  which  are  engaged  in  what  is  in  certain  ways 
a  species  of  commercial  activity,  as  well  as  by  providing 
capital  equipment  to  the  basic  value  element  in  the 
securities  involved,  during  what  we  may  term  the 
process  of  ''seasoning."  In  the  latter  case  the  specu- 
lator— a  special  class  of  individual  holder — supplies 
the  fluctuating  additional  amount.  Speculation  here 
performs  its  second  function — namely,  that  of  directing 
the  flow  of  capital  into  investment.  Turning  to  the 
last  form  of  investment,  direct  loans  to  the  individual 
enterprise,  in  order  to  involve  the  time  element,  are 
practically  made  for  employment  as  fixed  capital. 
There  is,  however,  a  shading  in  time,  both  of  loan  and 
of  operation  to  which  the  same  is  applied,  between 
such  loans  and  commercial  loans,  and  a  large  twilight 
zone  exists. 


IV 

LIMITATIONS  ON  LOANS  BY  NATIONAL  BANKS 

From  the  National  Bank  Act  as  amended,  the  Federal  Reserve  Act, 
and  other  laws  relating  to  national  banks.  Section  5200  (as  amended 
1919). 

(See  text,  pp.  144-46) 

"The  total  liabilities  to  any  association  of  any  per- 
son or  of  any  company,  corporation,  or  firm  for  money 
borrowed,  including  in  the  liabilities  of  a  company  or 
firm  the  liabilities  of  the  several  member  thereof,  shall 
at  no  time  exceed  10  per  centum  of  the  amount  of  the 
capital  stock  of  such  association,  actually  paid  in  and 
unimpaired,  and  10  per  centum  of  its  unimpaired  sur- 
plus fund:  Provided,  however,  That  (1)  the  discount  of 
bills  of  exchange  drawn  in  good  faith  against  actually 
existing  values,  including  drafts  and  bills  of  exchange 
secured  by  shipping  documents  convejnng  or  securing 
title  to  goods  shipped,  and  including  demand  obliga- 
tions when  secured  by  documents  co^'ering  commodi- 
ties in  actual  process  of  shipment,  and  also  including 
bankers'  acceptances  of  the  kinds  described  in  Section 
13  of  the  Federal  Reserve  Act,  (2)  the  discount  of  com- 
mercial or  business  paper  actually  owned  by  the  person, 
company,  corporation,  or  firm  negotiating  the  same, 
(3)  the  discount  of  notes  secured  by  shipping  documents, 
warehouse  receipts,  or  other  such  documents  conveying 
or  securing  title  covering  readil}^  marketable  nonperish- 
able  staples,  including  live  stock,  when  the  actual 
market  value  of  the  property  securing  the  obligations 
is  not  at  any  time  less  than  115  per  centum  of  the  face 


526  BANKING  AND   BUSINESS 

amount  of  the  notes  secured  by  such  documents  and 
when  such  property  is  fully  covered  by  insurance,  and 
(4)  the  discount  of  any  note  or  notes  secured  by  not 
less  than  a  like  face  amount  of  bonds,  or  notes  of  the 
United  States  issued  since  April  24,  1917,  or  certificates 
of  indebtedness  of  the  United  States,  shall  not  be 
considered  as  money  borrowed  within  the  meaning  of 
this  section.  The  total  habilities  to  any  association,  of 
any  person  or  of  any  corporation,  or  firms,  or  company, 
or  the  several  members  thereof  upon  any  note  or  notes 
purchased  or  discounted  by  such  association  and  secured 
by  bonds,  notes,  or  certificates  of  indebtedness  as 
described  in  (4)  hereof  shall  not  exceed  (except  to  the 
extent  permitted  by  rules  and  regulations  prescribed 
by  the  Comptroller  of  the  Currency,  with  the  approval 
of  the  Secretary  of  the  Treasury)  10  per  centum  of 
such  capital  stock  and  surplus  fund  of  such  association 
and  the  total  liabilities  to  any  association  of  any  per- 
son or  of  any  corporation,  or  firm,  or  company,  or  the 
several  members  thereof  for  money  borrowed,  including 
the  liabilities  upon  notes  secured  in  the  manner  de- 
scribed under  (3)  hereof,  except  transactions  (1),  (2), 
and  (4),  shall  not  at  any  time  exceed  25  per  centum  of 
the  amount  of  the  association's  paid-in  and  unimpaired 
capital  stock  and  sm-plus.  The  exception  made  under 
(3)  hereof  shall  not  apply  to  the  notes  of  any  one  person, 
corporation  or  firm  or  company,  or  the  several  members 
thereof  for  more  than  six  months  in  any  consecutive 
twelve  months." 


INTERBANK  LOANS 

Adapted  from  articles  by  W.  H.  Steiner,  in  Federal  Reserve  BtiUetin, 
June,  1920;  January,  May,  1921. 

(See  text,  pp.   182-84) 

The  methods  which  are  followed  in  extending  ac- 
commodation to  banks  differ  in  important  particulars 
from  those  followed  in  extending  accommodation  to 
mercantile  houses.  With  the  latter,  borrowing  is 
assumed  to  be  a  natural  and  recurring  operation.  The 
general  situation  of  the  enterprise  is  considered,  and 
on  this  basis  a  Une  of  credit  is  extended.  Borrowing 
by  a  bank,  however,  is  usually  not  so  regarded.  In- 
stead of  viewing  its  transactions  as  a  whole,  and  on 
this  basis  determining  the  line  of  accommodation,  it  is 
desired  rather  to  go  back  to  the  general  operations  and 
to  consider  the  specific  transactions  which  occur. 
This  is  the  case  to  the  extent  at  least  of  having  the 
paper  representing  these  transactions  as  collateral, 
and  analyzing  these  bills  receivable  to  some  extent. 
In  consequence,  no  line  of  credit  is  generally  fixed,  but 
each  individual  case  is  considered  on  its  merits,  specific 
amounts  being  granted  as  needed.  The  line  of  credit 
is  therefore  employed  only  in  a  somewhat  restricted 
sense.  The  position  which  is  taken  with  respect  to 
bank  bo^ro^^'ing  is  well  stated  by  one  institution  as 
follows:  "We  avoid  as  far  as  possible  suggesting  lines 
or  limits  as  to  the  extent  we  would  serve  the  borrower, 
simply  indicating  our  disposition  to  fully  meet  their 
reasonable  requirements  in  liberal  proportion  to  bal- 


528  BANKING   AND   BUSINESS 

ances  maintained  and  with  due  regard  to  the  amount 
of  their  capital  investment  and  borrowing  elsewliere, 
but  frequently  the  borrowers  suggest  lines  themselves 
which  are  agreed  to  if  circumstances  warrant,  condi- 
tioned on  everything  continuing  satisfactorily."  Some 
institutions,  however,  make  it  a  regular  practice  to 
fix  lines  for  their  bank  as  well  as  for  their  mercantile 
accounts,  while  some  institutions  fix  lines  only  for 
those  banks  which  are  regularly  in  need  of  funds  each 
year.  The  amount  loaned  is  also  limited  in  the  case  of 
national  banks  by  Section  5202  of  the  revised  statutes, 
covering  indebtedness  for  loans  or  rediscounts,  other 
than  with  the  Federal  Reserve  banks,  to  the  amount 
of  unimpaired  capital,  and  in  many  states  there  are 
provisions  covering  this  matter. 

The  practice  of  institutions  with  respect  to  credit  files 
on  their  bank  accounts  differs  greatly.  Some  institu- 
tions keep  a  very  elaborate  file,  whereas  others  rely 
much  more  largely  upon  the  general  acquaintance 
which  the  individual  officers  in  charge  have  with  the 
account.  In  a  broad  way  the  information  which  is 
considered  is  composed  of  the  following:  (1)  state- 
ments of  the  institution;  (2)  experience  of  other  institu- 
tions with  the  subject;  (3)  agency  reports,  which  are, 
however,  frequently  not  obtained;  (4)  reports  of 
representatives;  and  (5)  miscellaneous  data  such  as 
newspaper  clippings,  special  memoranda  concerning 
the  handling  of  the  account,  etc.  New  York  banks  in 
particular  pay  much  attention  to  the  experience  which 
other  institutions  have  had  with  the  subject,  and 
inquiry  is  usually  made  from  a  number  of  the  latter's 
correspondents  concerning  the  general  standmg  of  the 
bank  in  the  coimnunity,  its  prospects,  etc.,  the  char- 
acter, ability,  and  conservatism  of  its  management, 
and  the  relations  which  the  bank  has  had  with  the 
subject.     Some  of  the  Western  and  Southwestern  in- 


APPENDIX  529 

stitutions,  which  are  in  much  closer  contact  with  their 
borrowing  accounts,  do  not  make  it  a  practice  to 
communicate  extensively  with  their  correspondents, 
nor  do  they  regularly  employ  representatives  as  in  the 
case,  for  example,  of  New  York  banks. 

Borrowing,  in  general,  is  of  two  classes — (1)  for 
seasonal  needs  and  (2)  for  extraordinary  needs  and 
special  purposes.  Banks  generally  insist  that  the  bor- 
rower clean  up  its  loans  for  a  reasonable  part  of  each 
year.  The  seasonal  clean-up  is,  of  course,  pronounced 
in  those  sections  of  the  country  in  which  the  crops 
bulk  largest.  In  these  sections  the  time  of  crop 
moving  fixes  the  date  of  liquidation  of  the  loans,  and 
the  maturities  must  be  adjusted  accordingly.  Tem- 
porary accommodation  will  also  be  granted  where 
unexpected  or  large  withdrawals  of  deposits  occur,  or 
in  the  past  in  connection  with  government  finance. 
In  a  few  cases  continuous  borrowing  is  permitted 
where  banks  are  located  in  large  cities  which  lack  suf- 
ficient banking  capital  to  meet  continuous  borrowing 
demands.  In  granting  accommodation,  the  lending 
bank  considers  prominently  the  profitableness  of  the 
account  to  it,  as  represented  in  particular  by  the 
balance  which  is  kept  with  it. 

Accommodation  may  be  obtained  in  a  variety  of 
forms.  Paper  may  be  rediscounted  or  a  loan  may 
be  made.  This  loan  may  be  unsecured,  or  else  secured 
by  collateral  consisting  either  of  bills  receivable  or  of 
securities.  Loans  may  be  made  on  demand  or  for  a 
fixed  maturity.  Finally,  the  acconamodation  at  times 
may  be  extended  in  a  special  form,  such  as  through  the 
use  of  the  certificate  of  deposit,  or  by  sale  of  securities 
or  bills  receivable  with  repurchase  agreement. 

The  general  practice  is  to  extend  loans  rather  than 
to  grant  rediscounts.  There  are  relatively  few  un- 
secured loans.     Collateral  is  desired  for  the  assurance 


530  BANKING  AND   BUSINESS 

of  safety  which  it  gives.  Banks  on  the  whole  differ  in 
their  preference  with  respect  to  the  kind  of  collateral, 
some  preferring  bills  receivable,  while  others  prefer 
securities,  but  on  the  whole  the  collateral  consists 
mostly  of  bills  receivable.  In  the  agricultural  sections 
few  securities  are  used.  The  use  of  collateral  permits  a 
margin  which  provides  further  protection  to  the  lending 
bank.  This  varies  very  greatly  with  the  individual 
case,  the  customary  margin  perhaps  running,  however, 
from  10  to  25  per  cent. 

Practice  also  differs  with  respect  to  the  maturity  of 
loans.  Some  institutions  usually  have  demand  loans, 
while  others  strongly  prefer  loans  for  fixed  periods. 
This  varies  somewhat,  according  to  the  form  of  col- 
lateral employed,  and  loans  on  bills  receivable  are 
usually  for  fixed  periods.  A  favorite  maturity  is  60  to 
90  days.  The  collateral  is  generally  held  by  the  lending 
institution,  although  in  the  case  of  banks  in  distant 
parts  of  the  country  another  institution  may  hold  it 
under  trust  receipt.  The  collateral  is  generally  re- 
turned shortly  before  maturity  to  the  borrowing 
institution. 

Borrowing  against  certificate  of  deposit  is  rela- 
tively rare,  although  in  New  England,  on  the  Pacific 
coast,  and  in  the  Northwest  it  is  still  stated  to  be 
frequent.  In  some  cases,  also,  officers  or  directors 
may  arrange  for  accommodation  on  their  own  note, 
or  else  may  indorse  the  borrower's  paper  in  order  to 
provide  added  strength.  Purchase  of  securities  or  bills 
receivable  under  repurchase  agreement  is  at  times  also 
found,  and  this  may  be  done  for  special  purposes,  such 
as  in  connection  v/ith  taxation.  Most  of  the  special 
forms  of  accommodation  may  be  traced  to  a  con- 
tinuance of  the  prejudice  which  formerly  existed  against 
banks  showing  bills  receivable  or  rediscounts  in  their 
published  statements. 


VI 

THE  NEW  YORK  CALI^MONEY   MARKET 
From  the  Federal  Reserve  Bulletin,  April,  1920,  pp.  369-371. 

(See  text,  pp.  191-92) 

Definition  of  call  loans. — Collateral  call  loans,  in  the 
general  acceptance  of  the  term,  are  made  chiefly  in 
New  York  City,  which  is  practically  the  only  important 
call-money  market  in  the  United  States.  They  are 
loans  which  are  payable  on  demand  of  the  lender  with- 
out previous  notice,  secured  by  the  pledge  of  in\'cst- 
ment  securities,  i.e.,  stocks  and  bonds,  generally  those 
which  are  dealt  in  on  the  New^  York  Stock  Exchange. 
The  interest  rates  on  these  loans,  as  on  otlier  classes  of 
loans,  are  on  the  basis  of  a  rate  per  annum. 

The  borrowers. — The  loans  are  made  for  the  most 
part  to  houses  which  are  members  of  the  stock  exchange 
and  the  money  so  borrowed  constitutes  a  portion  of  the 
funds  employed  ordinarily  in  purchasing  and  carrying 
securities  for  their  customers  and  sometimes  for  them- 
selves. 

The  lenders. — The  principal  supplies  of  money  for  col- 
lateral call  loans  are  loanable  funds  of  banl:s  and  bank- 
ers located  both  in  and  outside  of  New  York  City,  in- 
cluding foreign  banks  and  agencies  of  foreign  banks; 
and  similarly  the  loanable  funds  of  firms,  individuals, 
and  corporations  seeking  temporary  in\'estment.  The 
proportion  of  the  whole  fund  loaned  by  these  several 
interests  varies  seasonally  and  in  accordance  with  the 
attractiveness  of  other  opportunities  for  investment, 


532  BANKING  AND   BUSINESS 

either  locally  or  in  other  markets.  The  bulk  of  call 
money  is  lent  on  the  floor  of  the  New  York  Stock 
Exchange  at  "the  money  post,"  where  through  various 
brokers  loanable  funds  are  offered  and  bids  for  funds 
are  received.  Most  of  the  business  is  done  between 
the  hours  of  12  noon  and  2.45  p.m.  The  important 
relation  to  the  money  market  of  the  present  system  of 
daily  settlement  of  balances  resulting  from  the  pur- 
chases and  sales  of  securities  on  the  stock  exchange  will 
be  discussed  more  fully  hereafter. 

Commercial  requirements  have  the  prior  claim. — In  the 
matter  of  the  supply  or  attraction  of  funds  to  the  call- 
money  market,  there  is  generally  a  definite  and  well- 
understood  obligation  on  the  part  of  banks  to  accom- 
modate first  their  own  commercial  clients,  so  that  it  is 
only  the  excess  of  loanable  funds  which  they  may  ha\-e 
from  time  to  time  that  is  available  for  the  collateral 
call-money  market  or  for  the  purchase  of  commercial 
paper  in  the  open  market.  This  excess  of  loanable  funds 
available  for  emplojrment  in  the  secmities  market 
varies,  therefore,  according  to  the  commercial  require- 
ments of  the  country.  It  has  long  been  recognized  that 
for  assurance  of  a  sufficient  amount  of  money  to  finance 
the  volume  of  business  in  securities,  rehance  cannot  be 
placed  on  a  rate  of  interest  limited  to  the  rates  which 
obtain  or  are  permitted  in  commercial  transactions 
whose  prior  claim  on  banking  accommodations  is  uni- 
versally conceded. 

CAUSES  AFFECTING  PRESENT  CALL-MONEY  RATES 

The  reference  in  the  congressional  resolution  to  high 
rates  for  call  money  in  the  financial  centers  and  the 
inquiry  as  to  their  causes  require,  it  is  felt,  a  survey  of 
the  operations  of  the  money  markets  and  the  reflection 
therein  of  the  underlying  economic  conditions  ^^lIich 


APPENDIX  533 

govern,  in  varying  degrees,  all  money  rates,  including 
those  for  call  money. 

Present  changed  conditions  of  supply. — In  former 
times,  and  specifically  prior  to  the  institution  of  the 
Federal  Reserve  system,  bankers,  especially  in  reserve 
centers,  were  accustomed  to  look  upon  call  loans  as 
their  principal  secondary  reserve  on  the  theoiy  that 
inasmuch  as  those  loans  were  payable  upon  demand, 
funds  so  invested  could  always  be  promptly  obtained 
on  short  notice  to  meet  withdrawals  of  deposits  or  for 
other  use.  In  these  circumstances  there  was  orcUnarily 
available  for  collateral  call  loans  a  supply  of  funds 
sufficient  for  ordinary  market  requirements  and  at  low 
rates,  although  at  times  the  rates  rose  to  high  levels 
as  the  supply  of  funds  diminished,  or  the  demands 
increased. 

This  attitude  of  the  banks  toward  call  loans  as  their 
chief  secondary  reserve  has  been  greatly  modified  by 
two  causes.  The  first  was  the  closing  of  the  stock 
exchange  at  the  outbreak  of  the  European  War  in  the 
summer  of  1914,  when  it  became  practically  impossible 
to  reahze  on  call  loans  secured  by  investment  securities, 
which  became,  therefore,  "frozen  loans."  This  resulted 
in  a  more  or  less  permanent  prejudice  against  depend- 
ence upon  call  loans  as  secondary  reserves.  The  second 
and  more  important  factor  was  the  creation  of  the 
Federal  Reserve  system. 

Under  the  terms  of  the  Federal  Reser\'e  Act  provision 
is  made  for  the  recUscount  of  commercial  paper,  but  the 
rediscount  of  loans  for  the  purpose  of  carrying  invest- 
ment securities,  other  than  ITnited  States  government 
obligations,  is  excluded.  Consequently,  in  order  to 
maintain  maximum  liquidity,  ^^^th  suitable  provision 
for  secondary  reserves  that  can  l)o  immediately  a\'ailed 
of,  banks,  including  foreign  agency  l)anks,  now  invest 
a  greater  proportion  of  their  resources  in  assets  that 


534  BANKING  AND   BUSINESS 

can  be  realized  upon  at  the  Federal  Reserve  bank. 
Another  changed  factor  in  the  present  situation  grows 
out  of  the  fact  that  the  war  and  postwar  conditions 
have  rendered  unavailable  supplies  of  money  which 
formerly  came  from  foreign  banks.  Since  the  summer 
of  1914,  while  total  banking  resources  have  largely 
increased,  the  volume  of  bank  money  available  to  the 
securities  market  at  low  or  normal  rates  has  not  in- 
creased proportionately,  but  on  the  contrary  has  prob- 
ably decreased.  All  of  these  circumstances  explain  in 
some  measure  the  increased  rates  which  have  often 
been  required  during  the  past  year  for  money  loaned  in 
the  securities  market. 

Present  changed  conditions  of  demand. — Changed  con- 
ditions are  also  present  in  the  factors  governing  the 
demand  for  money.  Prior  to  the  armistice,  agencies  of 
government  were  employed  to  restrict  the  issue  of  new 
securities  for  purposes  other  than  those  which  were 
deemed  essential  for  carrying  on  the  war.  At  the  same 
time,  as  the  Treasury  undertook  to  sell  large  amounts 
of  certificates  of  indebtedness  and  Liberty  bonds  bear- 
ing low  rates  of  interest,  the  question  arose  as  to  whether 
the  competition  of  the  general  investment  markets 
might  not  prejudice  the  success  of  the  government 
issues.  In  these  circumstances,  with  full  understanding 
on  the  part  of  the  Treasury  Department,  the  officers 
and  members  of  the  New  York  Stock  Exchange  under- 
took to  limit  transactions  which  w^ould  involve  the 
increased  use  of  money  for  other  purposes,  in  consid- 
eration of  which  the  principal  banks  of  New  York  City 
endeavored  to  provide  a  stable  amount  of  money  for 
the  requirements  of  the  security  market. 

After  the  armistice  these  restrictions  were  removed 
and  ordinary  market  forces  reasserted  themselves.  The 
issuance  of  new  securities  was  resumed  in  unprecedented 
volume  and  consumed  a  vast  amount  of  capital  and 


APPENDIX  535 

credit  when  bank  credit  was  already  expanded  by  the 
necessity  of  carrj-ing  large  amounts  of  government 
securities  which  the  investment  market  was  not  pre- 
pared to  absorb.  Thus  arose  a  further  cause  for  the 
increased  cost  at  times  of  accommodation  on  collateral 
call  loans. 

Since  the  armistice  these  causes  have  been  augmented 
by  the  increased  volume  and  velocity  of  transactions  in 
securities  generally.  Before  examining  the  figures,  it 
should  be  explained  that  the  amount  of  call  money 
employed  by  the  securities  market  fluctuates  according 
to  the  amount  of  other  funds  available  for  this  purpose, 
i.e.,  customers'  money  invested  and  time  money  bor- 
rowed, and  also  as  the  volume  of  business  varies. 

Volume. — The  volume  of  money  outstanding  on  call 
is  more  or  less  constant,  fluctuating  only  over  relati\'ely 
long  periods,  and  the  amount  which  is  loaned  from  day 
to  day  is  but  a  small  proportion  of  this  constant  volume. 
The  constant  volume  of  outstanding  call  loans  bears  a 
rate  of  interest  which  is  determined  daily  and  is  known 
as  the  renewal  rate.  The  daily  borrowings,  either  in 
replacement  of  loans  called  for  payment  or  representing 
new  money  borrowed,  are  made  at  rates  which  may  or 
may  not  be  the  same  as  the  renewal  rate  and  which 
frequently  vary  during  the  same  day. 

Turning  to  the  figures,  it  appears  that  over  a  period 
of  years  during  the  prewar  period  the  volume  of  all 
money,  both  time  and  call,  employed  in  the  securities 
market  was  estimated  at  about  $1,000,000,000,  of 
which  the  average  on  call  was  about  60  per  cent  and 
the  average  on  time  about  40  per  cent,  or  a  noiTnal 
volume  of  call  money,  say,  of  $600,000,000.  The  daily 
turnover  in  call  money,  i.e.,  old  loans  called  for  pay- 
ment, loans  made  in  replacement  thereof,  and  new 
money  borrowed,  ranged  from  $15,000,000  to  $30,- 
000,000,  and  averaged  about  $20,000,000.     The  daily 


536  BANKING  AND  BUSINESS 

turnover  during  the  year  1919,  however,  ordinarily 
ranged  from  $25,000,000  to  $40,000,000,  and  averaged 
about  $30,000,000.  Moreover,  it  is  important  to  notice 
there  has  been  a  disproportionate  increase  in  the  amount 
of  call  loans,  as  distinguished  from  time  money,  with  the 
consequence  that  the  former,  it  is  now  estimated,  con- 
stitute about  75  per  cent  of  the  total  money  employed 
in  the  securities  market.  At  a  time  of  such  heavy  credit 
requirements  as  the  present  the  greater  volume  of  bor- 
rowings, not  only  in  the  aggregate  but  in  the  day-to- 
day demands,  naturally  often  results  in  high  rates  for 
the  money  loaned.  Indeed,  so  reluctant  have  the  bank- 
ers been  during  the  past  few  months  to  supply  the  large 
demand  for  credit  based  on  securities  that  the  occasional 
loaning  of  relatively  small  amounts  of  money  at  very 
high  rates  often  represents  a  desire  not  to  secure  the 
high  rate  quoted  but  to  prevent  the  rate  from  going 
very  much  higher  with  the  consequent  demoraUzation 
which  might  result. 

Intermittent  factors. — There  are  certain  other  factors, 
the  influence  of  which  is  principally  manifested  in  inter- 
mittent wide  fluctuations  in  the  daily  rates  or  in  the 
rates  which  apply  for  brief  periods.  The  increased 
volume  of  demand  loans  called  daily  for  payment  noted 
above,  coupled  with  the  decreased  amount  of  time 
money  loaned  on  securities,  produces  more  or  less  appre- 
hension on  the  part  of  borrowers  as  to  their  abihty  to 
reborrow  money  called  for  payment.  This  apprehen- 
sion, quickened  by  the  number  of  insistent  borrower 
bidding  at  times  when  momentarily  loanable  funds  are 
exhausted  or  are  offered  in  small  quantity,  frequently 
results  in  competitive  bidding  for  funds  which  advances 
the  rates  for  a  day  or  part  of  a  day  beyond  the  actual 
necessities  of  the  situation. 

Another  active  and  important  influence  which  has 
recently  affected  the  supply  of  funds  available  for  col- 


APPENDIX  537 

lateral  loans  and  precipitated  at  times  a  rise  in  the  rates, 
has  been  the  periodic  transfers  of  government  deposits 
from  depositary  banks  to  the  Federal  Reserve  banks  in 
connection  with  the  fiscal  operations  of  the  Treasury. 
Such  withdrawals  result  in  the  depositary  banks  calling 
money  from  the  securities  market,  which  causes  sharp 
advances  in  the  rate  bid  for  call  money  in  replacement 
of  the  loans  called  for  payment. 

RATES  ARE  DETERMINED  BY  THE  OPERATION  OF  THE  LAW 
OF  SUPPLY  AND  DEMAND 

The  underlying  cause  of  fluctuations,  and  especially 
of  increases  in  call-money  rates,  is  the  operation  of  the 
law  of  supply  and  demand.  In  other  words,  as  the  sup- 
l)ly  of  loanable  funds  diminishes  in  proportion  to  the 
volume  of  the  demand,  the  rate  for  collateral  demand 
loans  advances.  However,  in  the  case  of  the  daily 
borrowings  of  call  money — to  which  the  abnormal  high 
and  low  rates  apply  and  which  represent  but  a  com- 
paratively small  proportion  of  the  total  outstanding 
loans — other  factors,  incidental  to  the  temporary  cir- 
cumstances and  conditions  of  the  market,  tend  in  times 
of  stress  to  greater  fluctuations  in  rates  than  result 
from  the  more  normal  operation  of  the  law  which  is 
reflected  in  the  renewal  rate  for  the  greater  \'olume  of 
the  outstanding  call  loans.  The  renewal  rate  is  regarded 
as  the  real  barometer  of  market  conditions,  and  its 
fluctuations  throughout  the  longer  periods  more  nearly 
reflect  the  relation  between  the  amount  of  the  loanable 
funds  and  the  amount  of  the  demand.  In  other  words, 
high  renewal  rates  are  mainly  due  to  other  tlemands  for 
credit,  resulting  in  part  from  the  increased  requirements 
of  the  commercial  community  and  in  part  from  other 
temporary  factors,  such  as  depletion  of  l)ank  reserves 
resulting  either  or  both  from  credit  expansion  or  loss  of 


538  BANKING  AND   BUSINESS 

reserves  through  gold  export,  speculation  in  commodities 
and  real  estate,  and  congestion  of  commercial  transac- 
tions incidental  to  slow  or  interrupted  transportation. 

Commercial  rates  are  similarly  and  independently  deter- 
mined.— The  operation  of  the  law  of  supply  and  demand 
is  equally  effective  in  determining  the  rate  for  commer- 
cial loans  and  all  other  borrowings.  In  fact,  rates  for 
commercial  loans  and  rates  for  collateral  loans  have  a 
common  root  in  the  law  of  supply  and  demand,  and  the 
conditions  which  affect  one,  in  the  main  affect  the  other, 
although  not  in  like  degree,  as  is  demonstrated  by  the 
far  wider  fluctuation  of  call  rates  and  the  higher  points 
to  which  they  go.  The  rates  for  call  money  do  not 
determine  and  have  not  exerted  an  important  influence 
on  the  rates  for  commercial  borrowings.  It  is  the 
universal  custom  of  the  banks  to  satisfy  first  the  com- 
mercial needs  of  their  customers.  They  feel  an  obliga- 
tion to  customers  but  none  to  those  who  borrow  in  the 
open  market  on  securities.  Besides,  as  the  resources 
of  the  banks  mainly  come  from  the  conamercial  cus- 
tomers, their  own  self-interest  compels  a  preference  in 
favor  of  their  commercial  borrowers,  since  failure  to 
grant  them  reasonable  accommodation  would  induce 
them  to  withdraw  their  deposits  and  so  reduce  the 
ability  of  the  banks  to  do  business.  Although  the  money 
of  the  banks  and  trust  companies  comprises  by  far  the 
greater  proportion  of  the  money  loaned  on  the  securities 
market,  an  examination  of  the  prevailing  rates  on  com- 
mercial paper  at  times  when  the  call-money  market  is 
particularly  strained  indicates  that  there  is  httlecasual  re- 
lation between  the  rates  for  call  money  and  those  on  com- 
mercial loans.  Exhibits  Nos.  1  and  2,  showing  respec- 
tively the  rates  for  call  money  on  the  New  York  Stock 
Exchange  during  the  years  1906-1919  and  the  rates  for 
commercial  paper  in  New  York  for  the  period  from  1915 
to  1920  are  attached.     (See  Bulletin,  pp.  368-74). 


APPENDIX  539 

POSSIBILITIES     OF     CHANGE     IN     THE     CONDITIONS     AND 
METHODS   OF   THE    CALLr-MONEY   MARKET 

So  long  as  collateral  call  loans  are  made  under  pre- 
vailing conditions  it  is  difficult  to  see  how  the  present 
situation  can  be  altered,  because  of  the  impracticabiUty 
of  controlUng  the  underlying  cause  of  high  rates,  which, 
in  the  last  analysis,  is  the  excess  demand  over  supply. 

An  attempt  to  control  the  rates  for  call  loans  by  the 
estabhshment  of  an  arbitrary  hmit  at  a  low  level,  with- 
out the  ability  to  modify  the  causes  above  enumerated, 
which  operate  to  increase  rates,  would  be  distinctly 
hazardous,  for  the  reason  that  up  to  the  point  where 
the  arbitrary  rate  would  limit  the  supply  of  new  money, 
speculation  and  expansion  might  proceed  unchecked 
and  the  natural  elements  of  correction  or  regulation 
would  not  obtain.  In  other  words,  high  rates  act  as  a 
deterrent  to  overspeculation  and  undue  expansion  of 
credit.  On  the  other  hand,  should  the  supply  of  money 
available  at  a  fixed  maximum  rate  become  exhausted, 
liquidation  might  suddenly  be  forced,  because  the  de- 
mands or  additional  accommodation  for  the  consum- 
mation of  commitments  already  made  could  not  be 
met.  The  effect  of  such  liquidation  would  be  to  em- 
barrass not  only  investors  and  dealers  in  securities,  but 
frequently  might  affect  dealers  and  merchants  in  com- 
modities as  well.  As  an  example  of  the  latter,  the  case 
might  be  cited  of  a  commitment  to  purchase  a  round 
amount  of  cotton  on  a  certain  day.  Many  of  the  houses 
on  the  cotton  exchange  are  also  members  of  the  stock 
exchange  and  frequently  borrow  very  largely  on  the 
stock  exchange  against  investment  securities  to  provide 
funds  for  settling  their  transactions  in  cotton.  If,  there- 
fore, when  an  important  cotton  settlement  is  imminent, 
borrowings  on  securities  could  not  be  availed  of,  the 
cotton  transaction  could  not  be  consummated  and  a 


540  BANKING  AND  BUSINESS 

drastic  liquidation  through  sale  either  of  securities  or 
of  the  cotton  might  be  required  to  avoid  default.  Simi- 
lar consequences  might  obtain  in  the  cases  of  transac- 
tions by  members  of  other  commodity  exchanges  who 
are  also  members  of  the  stock  exchange  and  have 
recourse  to  the  call-money  market. 

THE   IMPORTANCE    OF   A    "  CALL-MONEY "    MARKET 

Call  money  in  some  form  is  indispensable  to  every 
important  financial  center.  There  must  be  not  only 
an  outlet  for  the  employment  of  funds  temporarily  idle, 
but  a  large  volume  of  call  and  short-time  money  is 
essential  to  the  successful  and  economical  conduct  of 
business.  It  is  particularly  essential  to  the  international 
and  domestic  commercial  business,  but  the  diversion 
of  the  use  of  the  major  portion  of  such  money  to  the 
securities  markets  is  not  in  accordance  with  sound 
banking  principles.  It  is  to  be  noted  that  in  no  great 
world  market,  other  than  New  York,  is  the  call-money 
market  so  dependent  upon  investment  securities  and 
so  susceptible  to  speculative  influences.  In  other  mar- 
kets the  reverse  is  true,  as  their  call  money  is  based 
principally  on  commercial  paper  upon  which  reaUza- 
tion  can  be  had  at  the  central  bank,  at  a  price,  in  case 
of  need.  We  have  seen  that  in  this  country  call  loans 
on  securities  lack  this  essential  quahty  of  hquidity 
required  for  quick  and  certain  realization,  and  that  this 
fact  has  now  been  more  generally  taken  into  considera- 
tion by  our  lenders.  But  the  safe  and  successful 
divorce  in  this  country  of  the  use  of  call  money  from 
dependence  upon  investment  securities  as  a  basis  re- 
quires careful  study  in  order  that  safe  and  adequate 
methods  may  be  substituted  for  the  present  methods 
of  the  securities  market. 


VII 

STATEMENTS  OF  FOREIGN  BANKS 

(See  text,  pp.  372-80) 

Bank  of  England 
September  28,  1921 

(in  pounds  sterling) 

ISSUE  DEPARTMENT 

Notes  issued 145,044,950        Government  debt. . .     11,015,100 

Other  securities.  .  .  .       7,434,900 
Gold  coin  and  bullion  126,594,950 

145,044,950  145,044,950 

BANKING  DEPARTMENT 

Proprietors'  capital. .     14,553,000  Government  securi- 

Rest 3,529,568            ties 33,360.329 

PubUc  deposits! .  .  .  .     12,231,323        Other  securities 80,494,440 

Other  deposits 105,420,935         Notes 20,072,370 

Seven-day  and  other  Gold  and  silver  coin .  1,819,417 

bills 11,730 

135,746,556  135,746,556 

2.  Bank  of  France 
September  29,  1921 

(in  francs) 
ASSETS 

Cash  of  the  bank: 

Gold 5,523,095,774 

Silver 277,328,503  5,800,424,277 

Funds  abroad 622,295,048 

!  Including  Exchequer,  Savings  Banks,  Commissioners  of  National 
Debt,  and  Dividend  Accounts. 


542  BANKING  AND   BUSINESS 

Notes  due  yesterday 3,847,029 

Portfolio  of  branches ]  ,102,785,822 

Portfolio  of  Paris 1,426,748,591 

Advances  on  bullion  and  other  securities 2,188,214,223 

Advances  made  to  the  government 25,100,000,000 

Treasury  notes 4,084,000,000 

Various  rentes 2,304,368,958 

42,632,683,951 
LIABILITIES 

Capital  stock  of  bank  and  various  reserves 247,310,883 

Amortization  account  and  other  items 1,615,567,010 

Notes  in  circulation 37,129,458,260 

Arrears  on  funds  transferred  or  deposited 55,967,455 

Demand  notes 873,532 

Various  current  accounts 2,509,100,476 

Dividends,  interest,  and  other  items 1,074,406,335 

42,632,683^51 

3.  German  Reichsbank 
September  30,  1921 

(in  thousands  of  marks) 

ASSETS 

1921 

Bullion 1,039,768 

of  which  gold 1,023,704 

Imperial  debt  certificates 3,128,791 

Bank  notes  of  other  banks 2,613 

Drafts  and  checks 1,142,218 

Discount  treasury  notes 98,422,137 

Secured  loans 3,289 

Securities 277,977 

Other  assets •    5,994,777 

111,035,274 
liabilities 

Capital  stock 180,000 

Reserve  funds 121,413 

Circulating  notes 86,384,286 

Deposits:  Imperial  and  state 4,618,087 

Private 15,362,208 

Other  liabilities •  4,369,280 

111,035,274 


APPENDIX  543 


4.  Monthly  Statement  of  London  Clearing  Banks 

August,  1921 

(OOO'b  pounds  sterling  omitted) 
ASSETS 

Coin,  bank,  and  currency  notes  and  balances  with  the 

Bank  of  England 209,912 

Balances  with  and  cheques  in  course  of  collection  on 

other  banks  in  the  United  Kingdom 44,466 

Items  in  transit 

Money  at  call  and  short  notice 109,003 

Bills  discounted 383,280- 

Investments 315,476 

Advances  to  customers  and  other  accounts 816,724 

LiabiUties  of  customers  for  acceptances,  endorsements,  etc .  49 ,986 

Bank  premises  account 25,189 

Investments  in  afl&liated  banks 24,360 

Total 1,978,396 

Ratio  of  cash  to  current,  deposit,  and  other  accounts ...  11.0 

LIABILITIES 

Capital  paid  up 66,662 

Reserve  fund 51 ,673 

Current,  deposit,  and  other  accounts 1,806,910 

Acceptances,  endorsements,  etc 49,986 

Notes  in  circulation 3,014 

Reduction  of  bank  premises  account 151 

Total 1,978,396 


544 


BANKING   AND   BUSINESS 


5.  Consolidated  Statement  op 

(1)  Le  Credit  Lyonnais:    (2)  Le  Comptoir  National   d'Es- 
coMPTE  de  Paris;    (3)  Le  SocifiTfi G^n^rale  pour  Favoriser  le 

DfiVELOPPEMENT   DU    COMMERCE    ET   DE    l'InDUSTRIE    EN   FrANCE 
(in  thousands  of  francs) 


ASSETS 


Cash  in  vaults  and  balance  at 
banks 

Bills  discounted  and  short-time 
national  defense  securities . 

Advances  on  securities,  includ- 
ing stock-exchange  loans . . 

Debits  in  current  account 

Securities,  including  rentes .... 

Forward  exchange  opera tions^,  ^ 

Due  from  banks  and  bankers  - . 

Customers'  liabiUties  on  accept- 
ances 2 

Financial  participations  ',^ .  . . . 

Coupons  uncollected ' 

Agencies  outside  of  Europe  -. .  . 

Real  estate 

Sundry  assets  S  ^ 

Total 


Dec.  31, 1913    Aug.  31,  1920     Aug.  31,  1921 


470,967 

3,493,548 

1,058,257 

1,463.905 

63,200 

94,277 

175,076 

74,869 

42,300 

17,575 

101,410 

119,005 


7,174,389 


1,239,436 

8,756,985 

790,750 

3,423,314 

79,508 

231,621 

182,986 

89,270 
54,710 
20,117 

106,422 
189,542 


15,164,661 


1,188,775 

9,664,520 

580,395 

2,182,621 

68,369 

156,514 

156,294 

54,276 
42,122 
21,122 
11,675 
106,422 
236,898 


14,470,003 


APPENDIX 


545 


LIABILITIES 


Dec.  31. 1913 

Aug.  31.  1920 

Aug.  31.  1921 

Capital  paid  in 

700,000 
328,861 

2,071,097 

3,066,837 

296,865 

493,032 

18,371 
199,326 

732,038* 
318,780 

4,785,373 

8,035,653 

294,228 

200,829 

158,245 

231,621 

1,041 

10,910 

395,943 

750,000 
321,748 

4,788,837 

7,617,441 

243,649 

107,330 

Reserve 

Deposits    (checking    accounts, 
deposit  certificates  payable 
at  sight,  discount  accounts) 

Credits  in  current  account 

Deposits  payable  at  fixed  date . 

Acceptance  liabiUties 

Uncollected  funds  ' 

90,231 

Forward  exchange  operations ',  * 
Agencies  outside  of  Europe  ^. .  . 

Profit  and  loss  \^ 

Sundry  liabilities 

156,514 

V5,i24 
379,129 

Total 

7,174,389 

15,164,661 

14,470,003 

1  Le  Crddit  Lyonnais. 

*  Le  Comptoir  National  d'Escompte  de  Paris. 

'  Le  Soci6t(5  G(5n6rale  pour  Favoriser  de  D6velopperaent  du  Com- 
merce et  de  I'lndustrie  en  France. 

*This  increase  is  due  to  the  fact  that  the  Comptoir  National  d'Es- 
compte de  Paris  authorized  an  increase  of  50,000,000  francs  in  its 
capital,  of  which  32,038,000  had  been  paid  m  on  August  31,  1920. 


546 


BANKING  AND   BUSINESS 


Combined  Resources  and  Liabilities  of  the  Federal  Reserve 
Banks  at  the  Close  of  Business  on  Specified  Dates 


RESOURCES 


Gold  and  gold  certificates  . 

Gold  settlement,  F.  R.  B'd . 

Gold  with  foreign  agencies . 

Total  gold  held  by  banks. 


Gold  with  F.  R.  agents . 

Gold  redemption  fund . 

Total  gold  reserve.  .  . 


Legal-tendernotes,  silver,etc 
Total  reserves 


Bills  discounted: 

Secured  by  U.  S.  Gov't  ob- 
ligations   

All  other 

Bills  bought  in  open  market . 
Total  bills  on  hand 


U.  S.  bond  and  notes 

U.  S.  certificates  of  indebted- 
ness : 
One-year  certificates  (Pitt- 
man  Act) 

All  other 

Total  earning  assets 


Bank  premises 

5  per  cent  redemption  fund 
against  F.  R.  bank  notes 

Uncollected  items 

All  other  resources 

Total  resources 


Sept.  28,  1921   Scot.  21,  1921    Oct.  1.  1920 


$442,707,000 
415,765,000 

858,471,000 

1,759,065,000 

108.429,000 

2,725,966,000 

152,719,000 
2,878,685,000 


490,927,000 

911,976,000 

38,889,000 

1,441,792,000 

36,485,000 


175,375,000 

12,399,000 

1,666,051,000 

29,172,000 

9,086,000 

508.185,000 

15,947,000 

5,107,126,000 


$428,036,000 
411,210,000 

839,246,000 

1,777,529,000 

94,353,000 

2,711,128,000 

151,968,000 
2,863,096,000 


495,156,000 

892,081.000 

33,541.000 

1,420,751,000 

38,081,000 


184,875,000 

8,571,000 

1,652,278,000 

29,111,000 

8,917,000 

591,811,000 

16,448,000 

5,161,661,000 


$201,046,000 
362,468,000 
111,4.55,000 
674,969,000 

1,180,393,000 

147,710,000 

2,003,072,000 

162,123,000 
2,165,195,000 


1,183,017,000 

1,526,584,000 

301,510,000 

3,011,111,000 

26,924,000 


259,375,000 

12.107,000 

3,309,517,000 

15,455,000 

11,856,000 

819,165,000 

6,529,000 

6,327,717,000 


APPENDIX 


547 


LIABILITIES 


Capital  paid  in 

Surplus 

Reserved  for  gov't  franchise 

tax 

Deposits — Government.  .  . 
Member  banks — reserve  ac. 

All  other 

Total 

F.  R.  notes  in  actual  circu 
lation 

F.  R.  bank  notes  in  circula- 
tion— net  liabilities .... 

Deferred  availability  items . . 

All  other  liabilities 

Total  liabilities 

Ratio  of  gold  reserves  to  de- 
posit and  F.  R.  note 
liabilities  combined .... 

Ratio  of  total  reserves  to  de- 
posit and  F.  R.  note 
liabilities  combined .... 

Ratio  of  total  reserves  to 
F.  R.  notes  in  circula- 
tion after  setting  aside 
35  per  cent  against  de- 
posit liabilities 


Sept.  28,  1921 


$103,049,000 
213,824,000 

51,654,000 
57,253,000 

1,635,572,000 
24,580,000 

1,717,405,000 


2,457,196,000 

101.372,000 

441,300,000 

21,326,000 

5,107,126,000 


65.3% 
69.0% 

92.7% 


Sept.  21,  1921 


$103,017,000 
213,824,000 

50,777,000 
74,lba,000 

1,588,209,000 
29,218,000 

1,691,610,000 


2,474,676,0C>U 

103,5C0  000 

503,174,000 

20,993,000 

5,161,661,000 


65.1% 


68.7% 


91.8% 


Oct.  1.  1920 


$97,358,000 
164,745,000 


46,454,000 
1,776,243,000 

35,363,000 
1,858,060,000 


3,304,690,000 

213,412,000 

608,056,000 

81,390,000 

6,^27,717,000 


38.8%, 


41.9% 


45.8% 


VIII 

QUESTIONS  AND  ANSWERS  RELATING  TO  MEMBERSHIP 

OF  STATE  INSTITUTIONS  IN   THE  FEDERAL 

RESERVE  SYSTEM 

(Compiled  by  the  Federal  Reserve  Bank  of  New  York.) 

(See  text,  pp.  452-62) 

Rediscounting 

safety  for  depositors,  stockholders,  and 
borrowers 

Q.  1.  In  what  way  is  membership  of  advantage  to  a  bank 
or  trust  company? 

A.  Through  membership  in  the  Federal  Reserve 

system,  a  bank  or  trust  company  is  assured  of 
greater  safety  for  its  depositors  and  stock- 
holders than  when  operating  as  a  nonmember 
bank,  not  only  as  to  the  repayment  of  deposits, 
but  also  as  to  its  ability  to  continue  to  grant 
accommodation  at  all  times. 

Q.  2.  In  what  way  does  membership  insure  greater 
safety  to  the  institution,  its  depositors  and  stock- 
holders? 

A.  Nearly  every  bank  or  trust   company  has 

among  its  assets  a  considerable  amount  of  com- 
mercial paper.  If  it  is  a  member  of  the  Federal 
Reserve  system,  this  commercial  paper  is  prac- 
tically as  available  as  though  it  were  actual 
cash,  for  the  member  bank  can  at  any  time  take 
it  to  the  Federal  Reserve  bank  and  rediscount 


APPENDIX  549 

or  borrow  upon  it,  and  is  thus  in  position  to 
meet  whatever  demands  for  cash  it  may  have. 
Government  securities  and  notes  secured  by 
government  securities,  or  given  for  the  purpose 
of  purchasing  or  carrying  government  securities, 
may  be  used  in  the  same  way.  The  abihty  of 
the  well-managed  institution  to  meet  its  obliga- 
tions is  thus  assured. 


CERTAINTY   OF   ACCOMMODATION 

Q.  3.  How  does  this  affect  the  ability  of  a  bank  to  grant 
accommodation  to  its  customers? 

A.  The  ability  of  a  bank  to  grant  accommodation 

to  its  customers  under  our  system  of  banking 
is  dependent  upon  its  ability  to  maintain  a 
fixed  ratio  of  reserves  to  its  deposit  liability. 
As  additional  accommodation  is  extendetl,  de- 
posits increase,  and  a  larger  reserve  becomes 
necessary.  If  the  bank  cannot  obtain  this 
additional  reserve,  it  must  cease  extend- 
ing accommodation.  By  borrowing  from  the 
Federal  Reserve  bank  and  taking  credit  upon 
the  books  of  that  institution,  the  member's 
reserve  is  increased  and  its  power  to  extend 
accommodation  is  thereby  correspondingly  ex- 
tended to  a  maximum  amount  equal,  in  the 
case  of  a  country  bank,  to  about  fourte<Mi  times 
the  amount  it  borrows  from  the  Federal  Re- 
serve bank,  and  in  the  case  of  a  reserve  city 
bank  or  a  central  reserve  city  bank,  to  about 
ten  times  and  eight  times,  respectively. 

Q.  4-  How  much  can  a  member  bank  borrow  from  the 
Federal  Reserve  bank? 

A.  The  law  places  no  limitation  upon  the  amount 

which  a  particular  member  bank  may  borrow 


550  BANKING  AND   BUSINESS 

from  its  Federal  Reserve  bank,  and  the  only 
practical  limit  is  that  which  would  be  dictated 
by  the  banking  judgment  of  the  management 
of  the  Federal  Reserve  bank,  having  in  mind 
its  own  position  and  the  needs  of  all  the  other 
member  banks. 

Q.  5.  Can  a  member  hank  borrow  on  anything  besides 
commercial  paper? 

A.  Yes.     Obligations  of  the  United  States  gov- 

ernment are  available  as  collateral  for  loans 
made  by  the  Federal  Reserve  bank  to  its  mem- 
bers, and  notes  of  customers,  secured  by  United 
States  government  obligations,  or  given  for  the 
purpose  of  purchasing  or  carrying  government 
securities,  are  eligible  for  rediscount. 

PKACTICALLY     ALL     BANKS     HAVE     PAPER 
ELIGIBLE   FOR   REDISCOUNT 

Q.  6.  Banks  and  trust  companies  frequently  state  that 
they  do  not  hold  paper  of  a  kind  eligible  for  redis- 
count at  the  Federal  Reserve  bank.     Is  this  true? 

A.  The  experience  of  banks  and  trust  companies, 

ranging  from  very  small  banks  in  the  smallest 
communities  up  to  the  largest  institutions  of  this 
kind  in  the  country,  which  are  members  of  the 
system,  shows  conclusively  that  practically  all 
such  institutions  have  substantial  amounts  of 
paper  which  is  eligible  for  rediscount  at  the 
Federal  Reserve  bank,  and  the  institutions 
which  have  thus  far  joined  have  experienced  no 
difficulty  in  obtaining  from  the  Federal  Reserve 
bank  all  needed  accommodation. 

Q.  7.  Is  not  the  paper  held  by  the  smaller  banks  and 
trust  companies,  and  especially  those  in  small 
towns,  too  small  to  be  used  for  rediscounting? 


APPENDIX  551 

A.  No.     It  is  probable  that  the  small  institutions 

have  an  even  larger  proportion  of  eligible  paper 
than  the  larger  ones,  and  no  item  is  too  small 
in  size  to  be  used  for  this  purpose.  Notes  for 
amounts  as  small  as  S5  have  been  rediscount^d, 
and  items  of  $100,  §500,  and  SI, 000  and 
similar  amounts  constitute  the  bulk,  in  num- 
ber, of  Federal  Reserve  bank  rediscounts. 

Q.    8.   What  paper  is  eligible  for  rediscount? 

A.  Generally  speaking,  the  ordinary  notes,  single 

or  double  name,  which  a  bank  receives  from  its 
business  and  agricultural  borrowers. 

More  specifically,  eligible  commercial  paper 
includes  notes,  drafts,  or  bills  of  exchange 
having  a  maturity  of  not  more  than  ninety  days 
(or  agricultural  paper  having  maturity  of  not 
more  than  six  months),  the  proceeds  of  which 
have  been  used  or  are  to  be  used  in  actual  com- 
mercial transactions — i.e.,  in  purchasing,  carry- 
ing, or  marketing  goods,  or  in  one  or  more  of  the 
steps  of  the  process  of  production,  manufacture, 
or  distribution. 

Q.    9.  What  paper  is  not  eligihlef 

A.  Notes,  drafts,  or  bills  of  exchange  the  pro- 

ceeds of  which  ha^^e  been  used  or  are  to  be  used 
for  permanent  or  fixed  investments  of  any  kind, 
such  as  land,  buildings,  or  machinery,  or  similar 
instruments  issued  or  drawn  for  the  purpose 
of  carrying  or  trading  in  stocks,  bonds,  or  other 
investment  securities,  except  bonds  and  notes  of 
the  United  States,  are  not  eligible  for  rediscount, 

Q.  10.  Is  single-name  paper  eligible  for  rediscount? 

A.  Yes.     The  test  of  eligibility  is  not  the  numl)er 

of  names  on  the  paper,  but  whether  or  not  it 
was  issued  or  its  proceeds  used  for  some  in- 
30        dustrial,  commercial,  or  agricultural  purpi^se. 


552  BANKING  AND   BUSINESS 

Q.  11.  If  a  note  has  been  made  for  a  commercial  purpose, 
does  the  fact  that  it  is  secured  by  pledge  of  collateral 
security  make  it  ineligible? 

A.  No,  provided  it  is  otherwise  eligible. 


REDISCOUNTING   A   SIMPLE   OPERATION 

Q.  12.  Is  not  rediscounting  very  complicated? 

A.  No.     Items  intended  for  rediscount  are  listed 

on  an  application  blank  and  forwarded  to  the 
Federal  Reserve  bank,  which  gives  credit  on  the 
day  of  receipt,  and  notifies  the  applying  bank 
by  telegram  of  the  amount  placed  to  its  credit. 

Q.  13.  How  does  the  Federal  Reserve  bank  collect  notes 
rediscounted  with  it? 

A.  By  sending  them  to  the  discounting  member 

bank  about  a  week  before  maturity  with  the 
request  that  it  collect  them  as  agent  for  the 
Federal  Reserve  bank.  On  the  day  each  note 
matures,  it  is  charged  to  the  account  of  the 
discounting  member  bank. 

Q.  14'  What  information  is  a  bank  required  to  furnish 
concerning  paper  offered  for  rediscount? 

A.  In  applying  for  rediscount  the  member  bank 

lists  the  names  of  makers  and  indorsers, 
amounts,  maturities,  etc.,  and  the  proper  officer 
certifies  that  to  the  best  of  his  knowledge  and 
belief  the  paper  has  been  used  for  a  commercial, 
industrial,  or  agricultural  purpose. 

Q.  15.  How  is  the  member  bank  to  assure  itself  that  the 
paper  has  been  issued  for  such  a  purpose? 

A.  The  knowledge  of  the  officers  will  usually  en- 

able them  to  make  the  certificate,  but  if  they 
are  in  doubt  and  the  member  bank  has  a  finan- 
cial statement  of  the  borrower  or  an  indorser 
engaged  in  business  or  agriculture,  which  shows 


APPENDIX  553 

a  reasonable  excess  of  quick  assets  over  current 
liabilities,  the  statement  may  be  taken  as  evi- 
dence that  the  paper  has  been  issued  for  a  com- 
mercial or  agricultural  purpose. 

Q.  16.  Must  financial  statements  of  borrowers  be  furnished 
when  applying  for  rediscount? 

A.  The  regulation  of  the  Federal  Reserve  Board 

requires  that  whenever  a  member  bank  has  re- 
discounted  or  offers  for  rediscount  at  the  Federal 
Reserve  bank  obligations  of  one  name  to  the 
extent  of  $5,000  or  more  (or  in  the  case  of  banks 
having  a  capital  of  less  than  $50,000,  a  sum 
equal  to  10  per  cent  of  the  paid-in  capital  of  the 
bank),  it  shall  have  in  its  o^vn  files  a  statement 
in  respect  to  one  of  the  names  on  the  paper. 
The  purpose  of  this  requirement  is  to  stimulate 
member  banks  to  build  up  their  credit  files  and 
to  make  it  possible  for  them  to  get  statements 
from  borrowers  who  have  heretofore  been  un- 
willing to  give  statements.  No  statements  are 
required  to  be  submitted  to  the  Federal  Reserve 
bank  with  the  application  for  rediscount,  but  the 
member  bank  indicates  on  its  application  all  names 
■  in  respect  to  which  it  has  statements  on  file,  and 
the  Federal  Reserve  bank,  if  it  desires  copies  of 
any  of  these  statements,  will  later  ask  for  them. 
The  Federal  Reserve  Board  makes  no  require- 
ments whatever  regarding  statements  from  the 
smaller  borrowers. 

Collections,  Transfers,  and  Currency  Shipments 
economical  check  collection 

Q.  17.  What  service  does  the  Federal  Reserve  bank  render 
in  connection  with  the  collection  of  checks  and 
drafts? 


554  BANKING   AND   BUSINESS 

A.  The  Federal  Reserve  bank  collects  at  par  for 

member  banks  checks  on  over  21,000  banks  in 
all  parts  of  the  United  States,  including  all 
national  banks  and  a  considerably  larger  number 
of  state  institutions,  as  shown  in  a  par  list  fur- 
nished to  all  member  banks.  It  is  optional  with 
every  member  bank  whether  or  not  it  collects 
its  checks  through  the  Federal  Reserve  bank. 

Q.  18.  Is  there  any  charge  for  these  services? 

A.  No. 

Q.  19.  When  is  credit  given  for  checks  collected? 

A.  For  checks  on  banks  in  the  Borough  of  Man- 

hattan, received  before  9  a.m.,  immediate  credit 
is  given.  Checks  on  Boston,  Philadelphia,  Rich- 
mond, Norfolk,  and  Baltimore  are  available  one 
day  after  receipt.  For  other  checks  in  this  and 
near-by  districts  credit  is  given  two  days  after 
receipt  and  checks  on  more  distant  points  are 
credited  four  and  eight  days,  respectively,  after 
receipt. 

Q.  20.  How  should  checks  he  sent  to  the  Federal  Reserve 
hank  for  collection? 

A.  In  the  same  manner  as  remitted  to  other  cor- 

respondents, except  that  they  should  be  classi- 
fied according  to  time  of  availabiUty — i.e.,  one- 
day  items  listed  together  and  totaled,  two-day 
items,  likewise,  etc. 

Q.  21.  Can  checks  he  sent  direct  to  other  districts  or  must 
they  all  he  sent  through  the  Federal  Reserve  Bank 
of  New  York? 

A.  Arrangements    for    direct    sending    may    be 

made,  in  which  case  the  checks  are  sent  to  the 
Federal  Reserve  bank  of  the  receiving  district, 
as,  for  instance,  banks  in  Rochester  having 
checks  on  banks  of  the  Chicago  district  can  send 
these  items  direct  to  the  Federal  Reserve  Bank 


APPENJJIX  555 

of  Chicago  and  receive  credit  with  the  Federal 
Reserve  Bank  of  New  York  at  the  time  the 
checks  are  due  to  be  paid,  this  being  accom- 
phshed  by  the  Rochester  bank's  sending  a  duph- 
cate  remittance  shp  to  the  Federal  Reserve 
Bank  of  New  York  at  the  time  of  mailing  the 
original  remittance  and  items  to  the  Federal 
Reserve  Bank  of  Chicago.  The  moment  the 
checks  are  collected  in  Chicago  the  funds  auto- 
matically become  reserve  to  the  member  bank 
in  New  York. 
Q.  22.  How  are  items  on  member  banks  in  this  Federal 

Reserve  District  handled? 
A.  Items  dra^^^l  on  a  member  bank  are  mailed 

to  it,  and  the  member  bank,  upon  receipt  of 
the  items,  forwards  in  payment  draft  on  the 
Federal  Reserve  bank  or  other  funds  a\'ailable 
on  the  day  of  receipt,  thus  keeping  the  transac- 
tions separate  from  its  reserve  account. 
Q.  23.  Suppose  the  member  bank  has  not  sufficient  avail- 
able exchange  with  which  to  make  the  remittance? 
A.  The  member  bank  may  ship  currency  or  specie 

from  its  o^\^l  vaults  at  the  expense  of  the  Federal 
Reserve  bank, 
Q.  24'   What  are  the  advantages  of  collecting  checks  and 

drafts  through  the  Federal  Reserve  batik? 
A.  (1)  Greater  economy  in  collecting  these  items 
and  avoidance  of  the  necessity  of  main- 
taining balances  with  correspondents  in 
various  cities  in  order  to  obtain  check  col- 
lection facilities. 
(2)  The  most  direct  routing  of  items  possible, 
with  corresponding  reduction  in  the  length 
of  time  items  are  outstanding,  which  re- 
sults in  the  elimination  of  float  and  en- 
ables member  banks  and  their  customers 


556  BANKING  AND   BUSINESS 

to  learn  at  the  earliest  possible  moment 
whether  items  have  been  paid  or  dishon- 
ored, and  to  have  the  funds  represented 
begin  earning  interest  more  quickly. 

COLLECTION   OF   NOTES   AND   BILLS   OF   EXCHANGE 

Q.  25,  Does  the  Federal  Reserve  bank  also  collect  notes, 
drafts,  and  hills  of  exchange? 

A.  Yes.      Drafts,    notes,    coupons,    acceptances, 

etc.,  are  collected  without  charge  other  than 
any  exchange  charge  which  may  be  made  by 
the  collecting  bank.  For  items  returned  unpaid, 
an  additional  charge  of  fifteen  cents  is  made, 
the  purpose  of  this  charge  being  to  prevent  the 
clogging  of  our  faciUties  with  dunning  drafts. 

No  charge  is  made  for  collecting  coupons  other 
than  expenses  of  registration  and  insurance  or 
express,  plus  any  charge  made  by  the  collecting 
bank. 

MONEY   TRANSFERRED   WITHOUT   CHARGE 

Q.  26.  What  advantages  does  the  Federal  Reserve  bank- 
offer  in  transferring  funds? 

A.  The  Federal  Reserve  bank  makes  telegraphic 

transfers  of  funds  at  par  to  any  part  of  the 
United  States  for  its  members  without  any 
charge  whatever.  For  example,  upon  request 
from  a  member  bank  in  Utica  the  Federal  Re- 
serve Bank  of  New  York  would  wire  the  Federal 
Reserve  Bank  of  Dallas  to  pay  or  credit  to  any 
of  its  members  a  specified  sum,  no  charge  being 
made  for  this  service.  Such  transfers  may  be 
ordered  by  telegraph,  charges  collect. 

A  member  bank  may  also  draw  special  drafts 


APPENDIX  557 

on  its  Federal  Reserve  bank  for  amounts  not 
exceeding  $5,000  which  are  receivable  for  imme- 
diate availability  at  any  other  Federal  Reserve 
bank.  It  may  also  make  special  drafts  on  its 
Federal  Reserve  bank  which  are  payable  at  any 
specified  Federal  Reserve  bank,  no  limit  being 
placed  on  such  drafts.  In  either  case  the  mem- 
ber bank  must  advise  the  special  draft  to  its 
Federal  Reserve  bank,  which,  upon  receipt  of 
the  advice,  charges  the  amount  to  the  account 
of  the  member  bank.  The  member  bank  is  thus 
placed  in  position  to  obtain  \vithout  cost,  and 
furnish  to  its  customers,  exchange  on  any  of  the 
twelve  Federal  Reserve  cities  at  any  time  or 
season. 

These  facilities  are  made  possible  by  the  gold 
settlement  fund  which  the  twelve  Federal  Re- 
serve banks  maintain  at  Washington  and 
through  which  they  settle  daily  their  obligations 
to  one  another  by  transfers  on  the  books  of  the 
fund  instead  of  by  actual  shipments  of  currency 
or  coin.  The  gold  held  in  this  fund  amounted 
in  June,  1919,  to  almost  $600,000,000. 

CURRENCY 

Q.  27.  What  must  a  member  bank  do  to  obtain  Federal 
Reserve  notes  from  the  Federal  Reserve  bank? 

A.  Federal  Reserve  notes  in  denominations  of  $5, 

$10,  $20,  $50,  $100,  $500,  $1,000,  $5,000  and 
$10,000  are  shipped  to  member  banks  on  re- 
quest, by  registered  mail,  insured,  and  the  mem- 
ber bank's  account  cliarged  witli  the  face 
amount,  thus  providing  clean  currency  at  all 
times. 

The  Federal  Reserve  Board  has  authorized 


558  BANKING  AND  BUSINESS 

the  Federal  Reserve  banks  to  absorb  the  ex- 
penses in  connection  with  transactions  between 
them  and  their  member  banks,  as  follows: 

(a)  Payment  of  all  postage,  express  charges, 
insurance,  etc.,  incident  to  shipments  of 
currency  to  and  from  member  banks;   and 

(b)  Payment  of  charges  on  all  telegrams  received 
from  or  sent  to  member  banks  in  connection 
with  currency,  exchange  transfers,  and  de- 
posit transactions. 

Shipments  of  gold,  gold  certificates,  silver 
certificates,  and  legal- tender  notes  may  be  made 
to  the  Federal  Reserve  Bank  of  New  York  either 
by  express  or  by  registered  mail  for  credit  of  the 
member  bank's  account  or  for  exchange  for 
Federal  Reserve  notes.  We  pay  transportation 
charges  on  gold,  gold  certificates,  and  silver  cer- 
tificates, whether  fit  or  unfit  for  circulation,  and 
also  furnish,  free  of  expense,  Federal  Reserve 
notes  in  exchange. 

Q.  28.  In  what  amounts  are  Federal  Reserve  notes  avail- 
able? 

A.  The  Federal  Reserv^e  bank  is  not  Hmited  as  to 

the  amount  of  notes  which  it  may  issue,  except 
by  the  provision  that  a  40-per-cent  gold  reserve 
must  be  maintained  against  Federal  Reserve 
notes  in  actual  circulation. 

The  Federal  Reserve  Bank  of  New  York  now 
has  in  actual  circulation  approximately  $760,- 
000,000  of  Federal  Reserve  notes.  It  always 
maintains,  ready  for  issuance,  a  very  large  sup- 
ply of  unissued  notes,  which  assures  member 
banks  of  an  ample  currency  supply  at  all  times. 

Q.  29.  Can  the  Federal  Reserve  bank  supply  $1  and  $2 
notes? 

A.  Yes.     The  Federal  Reserve  bank  is  at  present 


APPENDIX  659 

issuing  Federal  Reserve  bank  not-es  of  these 

denominations,  which  can  be  supplied  in  the 

same  manner  as  other  currency. 
Q.  30.  Does  the  Federal  Reserve  bank  furnish  subsidiary 

silver  coin  and  minor  coins? 
A.         Yes.     It  will  furnish  such  coins  and  pay  cost  of 

shipment  thereon. 


IX 

SELECTED  LIST  OF  COLLATERAL  READING 

1.  Exchange 

Fisher,  I.,  Purchasing  Power  of  Money. 
Laughlin,  J.  L.,  Principles  of  Money. 
Todd,  J.  A.,  Mechanism  of  Exchange. 

2.  Credit 

Cleveland,  F.  A.,  Funds  and  Their  Uses. 

Ettinger,  R.  P.,  and  Golieb,  D.  E.,  Credits  and  Collections. 

Hagerty,  J.  E.,  Mercantile  Credit. 

Phillips,  C.  A.,  Bank  Credit. 

Taylor,  W.  G.  The  Credit  System. 

Wall,  A.,  Analytical  Credits. 

Bankers'  Credit  Manual. 

3.  Credit  Instruments 

Huff  cut,  E.  W.,  Elements  of  Business  Law. 

McMaster,  W.,  Irregular  and  Regular  Commercial  Paper. 

4.  Commercial  Banking 

Barrett,  A.  R.,  Modern  Banking  Methods. 
Bordwell,  G.  0.,  Modern  Banking  Methods. 
Dunbar,  C.  F.,  Theory  and  History  of  Banking. 
Ebersole,  J.  F.,  Elementary  Banking. 
Fiske,  A.  K.,  The  Modern  Bank. 
Holdsworth,  J.  T.,  Money  and  Banking. 
KniflSn,  W.  H.,  Business  Man  and  His  Bank. 

Practical  Work  of  a  Bank. 

Langston,  L.  H.,  Practical  Bank  Operation. 
Moulton,  H.  G.,  Money  and  Banking/. 

Financial  Organization  of  Society. 

Phillips,  C.  A.,  Readings  in  Money  and  Banking. 
Shaw  Series:  Advertising  and  Service. 


APPENDIX  561 

Accounting  and  Costs. 

Loans  and  Discounts. 

Executive  Control. 

Buildings,  Equiptnerit,  and  Supplies. 

Credit  and  Collections. 
Willis,  H.  P.,  American  Banking. 
Wolfe,  0.  H.,  Practical  Banking. 

5.  Foreign  Exchange 

Bastable,  C.  E.,  Theory  of  International  Trade. 
Brown,  H.  S.,  International  Trade. 
Escher,  F.,  Foreign  Exchange  Explained. 
Goschen,  G.  J.,  Theory  of  Foreign  Exchange. 
Hobson,  C.  K.,  Export  of  Capital. 
Margraff,  A.  W.,  I  liter  national  Exchange. 
Spalding,  W.  F.,  Bankers'  Credits. 

Eastern  Exchanges. 

Whitaker,  A.  C,  Foreign  Exchange. 
York,  T.,  Foreign  Exchange. 

6.  Investment  Banking 

Chamberlain,  L.,  Principles  of  Bond  Investment 
Dewing,  A.  S.,  Financial  Policy  of  Corporations. 
Gerstenberg,  C.  W.,  Materials  for  Corporation  Finance 
Lagerquist,  Investment  Analysis. 
Lyon,  H.,  Corporation  Finance. 

7.  Savings  Banking 

Hamilton,  J.  H.,  Savings  and  Savings  Institutions. 

Kemmerer,  E.  W.,  Postal  Savings  System. 

Knifl&n,  W.  H.,   Savings  Bank  and  Its  Practical  Work. 

8.  Trust  Companies 

Herrick,  C,  Tru^t  Companies. 

Kirkbride,  Sterrett,  and  Willis,  Modern  Trust  Company. 

9.  Banking  System 
Agger,  E.  E.,  Organized  Banking. 
Bagehot,  W.,  Lombard  Street. 

Conant,  C.  A.,  History  of  Modern  Banks  of  Issue. 
Hepburn,  A.  B.,  History  of  Currency. 


662  BANKING  AND   BUSINESS 

Hollander,  J.  H.,  War  Borrowing. 

Keninieror,  E.  W.,  A.  B.  C.  of  the  Federal  Reserve  System. 

Lauffhlin,  J.  L.,  Banking  Progress. 

Mitchell,  W.  C,  History  of  the  Greenbacks. 

National  Monetary  Commission  Reports. 

Noyes,  A.  D.,  Forty  Years  of  American  Finance. 

PhilJipovich,  E.,  Bank  of  England. 

W-dvhurg,  P.  M.,  Essays  in  Banking  Reform. 

Willis,  H.  P.,  The  Federal  Reserve. 

10.  Money  and  Prices 

Anderson,  B.  M.,  Value  of  Money. 

Hobson,  J.  A.,  Gold  Prices  and  Wages. 

Kemmerer,  E.  W.,  High  Prices,  Inflation  and  Deflation. 

Laughlin,  J.  L.,  Money  and  Prices. 


INDEX 


Acceptance: 

unqualified,  30. 

qualified,  32. 

in  bank  portfolio,  146-47,  149. 

customer's  liability  under,  166. 

agreement,  166,  276. 

eligibility  of,  193. 

market,  193. 

charge  for,  193. 

rate,  193-94. 

refinancing,  276. 

as  investment,  326. 
Account  {See  deposit). 

accounts  receivable,  115. 

accounts  payable,  117. 
Accrued  liabilities,  171. 
Aldrich  bill,  420-26. 
Aldrich-Vreeland  Act,  421,  434. 
American  Bankers'  Association: 

numerical  system  of,  86. 

Edge  corporations  proposed  by, 
283. 
Amortization,  324,  345. 
Arbitrage: 

definition  of,  268. 

classification,  268. 

illustration  of,  268-69. 
Arizona,  banking  law  of,  215. 
Articles  of  association,  62. 
Assets: 

borrower's,  114-16. 

need  of  liquid,  136-39. 

bank,  10.=>-69. 

examination  of,  219-21. 
Audits,  92,  225-26. 
Authority  to  i)urchase,  276-77. 


B 

Balance : 

reconcilement  of,  77. 

purpose  of  bank,  240-41. 
"Baltimore  plan,"  416-17. 
Banco  dc  Chile,  384. 
Banco  de  la  Naciou,  383. 
Bank: 

function  of,  7,  19,  21,  23, 123,  128, 
479,  496. 

definition  of,  8,  11-12,  18. 

classification  of,  46-48. 

co-operation,  157-58,  360-61. 

inflation,  161. 

similarity  to  public-service  cor- 
poration, 186,  213. 

compared   with   ordinary   busi- 
ness, 213. 

supervision,  215-16,  466-70. 

examination,  217-23. 

number  of,  234. 

colonial,  356. 

integration,  359. 
Bank  Act  of  1844,  372. 
Bank  of  China,  386. 
Bank  of  England: 

importance  of,  354. 

branches  of,  355. 

reserves  of,  355. 

history  of,  372. 

function  of,  372. 

effect  of  war  on,  373. 

control  of  market  by,  373. 

statement  of,  541. 
Bunk  of  France: 

history  of,  375. 

branches  of,  376. 


564 


BANKING  AND   BUSINESS 


rolation  to  the  public,  376. 

fiscal  agent,  377-78,  385. 

statement  of,  541. 
Bank  of  Japan,  385. 
Bank  of  Switzerland,  382. 
Bank  of  Taiwan,  385. 
Banking:  cost.  Chapter  XIII. 

regulation  of.  Chapter  XIV. 

systems,  Chapter  XXII. 

abroad,  Chapter  XXIII. 

government     and,     Chapter 
XXVII. 

economic  significance  of.  Chap- 
ter XXIX. 

relation  to  prices,  128-30,  489- 
92. 

independent  system  of,  143. 

classes  of,  354. 

in  Great  Britain,  354-56. 

independent,  chartered,  356-58. 

specialized,  361,  363-65. 

heterogeneous,  361,  362-63. 

development  of,  362-63,  367-68. 

determined  by  legislation,  363- 
65. 

relation  to  business,  367-68. 

centralized,  371. 

decentralized,  371. 

development  of  German,   378- 
80. 

South  American,  382-85. 

study  of  history  of,  389. 

safety-fund  plan  of,  400. 

relation  to  money,  478-80. 

and  exchange,  492-96. 

permanence    of    present   form, 
499-503. 

and  economic  institutions,  500- 
501. 

future  of,  501-03,  507-08. 

public-service  nature  of,  503-05. 

standardization  of,  503-04. 

relation  to  industry,  507-08. 

function  of,  508. 
Barter,  10,  11. 
"Batch"  system,  77. 
Bill  of  lading: 

purposes  of,  271. 


order,  271-72 

straight,  272. 

Act,  272. 
Bill   of   exchange,  120,  121,  137, 
144,  147. 

classes  of,  30. 

definition  of,  34,  253. 

documentary,  137. 

foreign,  141. 

payable,  172-73. 

purchased,  166. 

trade,  261. 

unsecured,  261. 

secured,  261-62. 

rates  on,  263-64. 

discounting  of,  274. 
"Block"  system,  77. 
Bond: 

debenture,  43. 

registered,  44. 

similarity   to   short-term   note, 
44. 

examination  of,  221. 

houses,  304. 

as  investments,  324-25. 

transfer  of,  343. 
Book-account,  28. 
Bookkeeping  department,  91-92, 

104. 
Borrower's  statement,  content  of, 

114-17. 
Branch  banking,  12-13,  234,  381, 
388. 

interbank  relations  under,  243- 
44. 

under  Federal  Reserve  Act,  282. 

under  New  York  law,  282. 
British  banks  and  business,  286. 
Building-and-loan  association,  54. 
Business,  financing  of,  287-88. 
Business  organization: 

elements  of,  5. 

tjrpes  of,  59. 


Cable  transfer: 
meaning  of,  260. 
rates  on,  263-64 


INDEX 


565 


Call  market: 

definition  of,  191. 

rate  in,  191,  193,  532-34,  o35. 

economic  service  of,  192. 

savings  banks,  and,  326. 

operation  of,  531-40. 

money  post  of,  532. 
Calls  of  the  Comptroller,  217. 
Canadian  banks,  234,  380-82. 
Capital: 

relation  to  loans,  147-48,  170. 

movement  of,  255. 
Capital  stock: 

requirements  of,  62-64. 

paid-in,  63. 

characteristics  of,  62-63. 

earnings  on,  64. 

no  par  value  to,  64. 

meaning  of,  169. 
"Carrying,"  meaning  of,  307. 
Ca.sh,  examination  of,  219-20. 
"Ca.sh"  item,  82. 
Cashier,  duties  of,  72-73. 
Cashier's  check,  172. 
Central  bank  rate: 

meaning  of,  194-95. 

theory  of,  195-97. 

credit  policy  and,  196-99. 

market  rate  and,  197-98. 
Certificate  of  protest,  40. 
Certificate,  stock,  41. 
Certificate  of  deposit: 

meaning  of,  97. 

classification  of,  97-98. 

reserve  against,  227-28. 
Certificate  of  indebtedness,    166, 

177. 
Certification  of  check,  80,  172. 
Charter,  special,  46,  60. 
Charges,  determination  of  bank, 

186. 
Check: 

meaning  of,  33. 

ante-dating  and  post-dating  of, 
79. 

cashing  of,  79-80. 

certification  of,  80. 

in  foreign  exchange,  260. 


use  of,  in  England,  and  France, 
375. 
Chicago     banks,    clearing  -  house 

examination  by,  223-24. 
City  items,  collection  of,  83-85. 
Clayton  Act,  69. 
Clearing : 

compared  with  collection,  240. 

local,  244-48. 

procedure  of,  236-38. 
Clearing-house  associations : 

operation  of,  83. 

and  interest  rates,  104. 

examinations  by,  223-25. 

meaning  of,  236. 

country,  239,  248. 

function  of,  245. 

statement  of,  246. 

certificate  of,  247,  415. 

settlement  by,  217. 

fines  of,  248. 
Coinage  of  Japan,  385. 
Collateral,  form.s  of,  90-91,  144- 

45. 
"Collection"  item,  81. 
Collection : 

of  city  items,  83-84. 

country  items,  85-86. 

of  coupons,  88-89. 

procedure  of,  235-36. 

compared  with  clearing,  240. 

of  foreign  bills,  275. 

under  Federal  Reserve  sj-stcm, 
460-01. 
Colonial  banking,  356-58. 
Commeroiul  letter  of  credit  {See 

letter  of  credit). 
Commercial  agencies,  112-13. 
Commercial  banking  (Ste  Part  II). 

compared  with  savings  banking, 
311-12. 

compared  with  fiduciary  busi- 
ness, 337-38,  348. 

compared  with  investment,  521- 
24. 
Commercial  invoice,  273. 
Commercial-paper  house: 

uieaiiiiig  of,  51. 


566 


BANKING  AND   BUSINESS 


function  of,  125. 

organization  of,  125-26. 
Commercial  -  paper  market,  141- 

42. 
Commonwealth     Bank    of    Aus- 
tralia, 357,  4G4. 
Comptroller  of  the  Currency : 

appHcation  for  incorj)oration  to, 
61. 

directors  prosecuted  by,  68. 

statements  submitted  to,  164. 

creation  of  office  of,  215. 

duties  of,  215-16. 

function  of,  215-16. 

reports  to,  217. 

examination  division  under,  218. 

report  on  bank  failures  by,  232. 

receiver  appointed  by,  233. 

savings  deposits  defined  by,  328. 

inadequate  control  by,  468. 
Concentration  in  banking,  55-56. 
Consular  invoice,  273-74. 
Co-operative  banking,  54. 
Corporation,  financial  department 

of,  509-10. 
Correspondent  bank,  services  of, 
241,  367. 

in  foreign  countries,  282. 
Cost: 

determination  of,  203-05. 

reserve  as  an  item  of,  205-09. 

methods  of  limiting,  209-10. 

external  items  of,  210-11. 
Cost  analysis  of,  211-12.  ■ 
Country  items,  collection  of,  85- 

86. 
Coupons,  collection  of,  88-89. 
Credit: 

definition  of,  8,  10-11,  515-16. 

transactions,  8,  10. 

personal,  14. 

commercial,  14,  24,  26. 

classes  of,  14. 

bank,  15. 

mercantile,  15. 

public,  15. 

production,  16. 

short-term,  16,  24. 


long-term,  16,  25,  26,  154. 

time  element  in,  17,  24-25. 

relation  to  money,  20. 

basis  of,  21. 

transfer  of,  22. 

guaranteeing  of,  22. 

study  of  bank,  23. 

investment,  25,  26. 

period  of,  108-10. 

line  of,  112. 

oversight  of,  by  bankers,  120- 
21. 

interbank,  151. 

rationing  of,  156-57,  197. 

extension  of,  495,  505-06. 

rural,  504. 

scientific  study  of,  506. 
Credit  department,  21,  89-90. 
Credit  folders,  89,  114. 
Credit  information : 

source  of,  112-14. 

means  of  securing  foreign,  270. 
Credit  instruments  {See  Chapter 
III). 

definition  of,  28. 

types  of,  2&-33. 

legal  aspects  of,  33-41. 

classes  of  investment,  41-44. 
Credit  system: 

development  of,  9-10,  12, 

operation  of,  14. 
Credit  union,  55. 
Currency,  487. 

and  banlcing,  370. 
Currency  and  Bank   Notes  Act, 
1914,  373. 

D 

Deflation : 

meaning  of,  160,  162,  494. 

results  of,  162-63. 
Deposits : 

taken  by  receiving  teller,  76. 

special,  95-96. 

general,  96-97. 

pubUc,  98-99,  172. 

fiduciary,  99. 

private,  99-100. 


INDEX 


567 


individual,  99. 

opening  of,  99-100. 

securing  new,  100-101. 

payment  of  interest  on,  101-103. 

rate  of  interest  on,  103-105. 

demand,  172,  228. 

time,  172,  228. 

examination  of,  222. 

savings  bank,  31G-17. 
Directorates,  interlocking,  09. 
Directors: 

election  of,  65. 

qualifications  of,  66. 

duties,  66-67. 

compensation,  67. 

number  of,  67. 

liabilities  of,  68-69. 

examinations  by,  225-26. 
Discount  company,  51. 
Discount  ledger,  91. 
Discount  rate: 

advance  of,  156. 

affected  by  war  finance,  198. 
Dividends,  unpaid,  170. 

report  of,  217. 
Division  of  labor: 

basis  of,  4. 

continuation  of,  500-01. 
Draft:   (/See  bill  of  exchange). 

E 
Edge  Act,  283. 
Elasticity,  292. 

England,  bank  personnel  in,  296. 
Escrow,  346. 
Examination: 

by  government,  217-23. 

objects  of,  218,  219. 

organization    of    division     for, 
218-19. 

cost  of,  219. 

by  clearing  house,  223-25. 

by  Federal  Reserve  banks,  223. 

compared  with  audit,  225-26. 

internal,  225. 
Exchange,  evolution  of,  4. 

medium  of,  7. 

transactions  in,  7-8. 

37 


classification  of  items,  81-83. 
difference  between  domestic  and 

foreign,  252-53. 
influence  on  market,  492. 
relation  to  banking,  492-96. 
Expen.ses,  operating,  201-02. 
overhead,  202-203. 


Failures,  causes  of  bank,  232. 
Far  East,  financing  of  trade  with, 

277. 
Farm  financing,  507-08. 
Farm-loan  banks,  476. 
Federal  Advisory  Council,   func- 
tion of,  451-52. 
Federal  Reserve  Act : 

reserve      requirements    under, 
227-28. 

interbank  relations  under,  242. 

foreign  branches  permitted  by, 
282. 

savings  deposits  defined  by,  328. 

trust  powers  granted  by,  337-38. 

features  of  original  bill,  426-31. 

legislative  history  of,  426-39. 

congressional  action  on,  431-36. 

contents  of,  436-39. 

changes  by  Senate  in,  437. 
Federal  Reserve  agent,  450,  451. 
Federal  Reserve  Bank: 

settlement    of     clearing-house 
balances  by,  79. 

collection  by,  85. 

stock  of,  167,  174. 

rediscounts  by,  173. 

examinations  by,  223. 

bank  balances  with,  248-49. 

supervision  of,  449. 

directors  of,  449-50. 

statement  of,  546—17. 
Federal  Reserve  Board: 

Clayton  Act,  70. 

Edge  corporations  regulated  by, 
283. 

composition  of,  440. 

functions  of,  441. 

adruiniiitrative  duties  of,  441-43. 


568 


BANKING  AND   BUSINESS 


constructive  duties  of,  443-44. 
educative  duties  of,  444-45. 
organization  of,  445-49. 
Federal  Reserve  Districts,  map  of, 

448. 
Federal  Reserve   system:    Chap- 
ters XXV  and  XXVI. 
interlocking  directorates  under, 

69. 
clearings  under,  249,  553-57. 
state  bank  membership  in,  366, 

548-59. 
outside  membership,  452-56. 
rediscounts  under,  550-53. 
Fiduciary  deposits,  99. 
Finance  corporation,  51. 
Financial  departments  of  business 

houses,   509-10. 
First  Bank  of  the  United  States: 

organization  of,  390-96. 
Foreign  department,  organization 

of,  281. 
Foreign  exchange.  Chapter  XVI: 
compared  with  domestic,  252- 

53. 
meaning  of,  252-53. 
demand  and  supply  of,  253-57. 
market  for,  257,  259. 
seUing  rate  of,  265. 
buying  rate  of,  265. 
quotations,  265-66. 
future  contract  in,  266-67. 
trading  in,  266-69. 
hedging  in,  267. 
speculation  in,  267-68. 
arbitrage  in,  268-69. 
collection  of,  275. 
Fowler  bill,  422. 
Free  banking  system,  358-59,  400, 

466. 
"Frozen"  credit,  128,  132. 
Future  contract,  266. 

G 

Gold: 

international  movement  of,  255. 
efforts  to  conserve  supply  of, 
381. 


Gold  points,  254-55. 

Gold   settlement   fund,    clearings 

through,  249-50. 
Gold  Standard  Act,  417-19. 
Government: 

control  of  banks  by,  213,  462- 

63. 
ownership  of  banks  by,  463-66. 
supervision,  468-69. 
deposits  by,  470-71,  473. 
and  central  bank,  475. 
aid  to  special  producers,  476- 
77. 
Guaranty  -  fund     bank    of     New 

Hampshire,  328-29. 
Guaranty    fund    of    Canadian 

banks,  357,  381. 
Great  Northern:    Northern  Paci- 
fic railroad,  bond  issue  of,  49. 

H 
Hansa  merchants,  as  investment 

bankers,  299. 
"Hard  money"  policy,  473,  475. 
Hedging,  267. 
"Holder  in  due  course,"  34. 


Income,  sources  of,  Chapter  XII. 
Incorporation : 

law  of,  46. 

advantages  of  bank,  59. 

disadvantages,  60. 

reasons  for,  60. 

steps  in,  61-62. 
Independent  treasurj^: 

reasons  for  establishing,  403. 

as  fiscal  agent,  403-04,  473. 

failure  to  meet  needs,  405. 

effect    of   withdrawal    of    cash 
from,  473-74. 
Index  numbers,  481-84. 
Indiana,  State  Bank  of,  401. 
Indianapolis    Currency    Commis- 
sion, 417. 
Individual  and  corporate  trustees 
compared,  333-34. 


INDEX 


569 


Indorsement : 

purpose  of,  37. 

classification  of,  38. 

unqualified,  84. 

blank,  86. 
Industrial  Bank  of  Japan,  385. 
Industry,    relation     to    banking, 

507-08. 
Inflation,  160: 

development  of,  160-61. 

definition  of,  160,  494. 

effect  on  prices,  161. 

results  of,  161;  377. 
Instruments,  commercial  credit. 

Chapter  III. 
Insurance  policy,  272-73. 
Interbank,  organization,  242-44. 
Interest  loans: 

on  deposits,  101-03. 

rate  of,  103-05. 

computation  of,  104. 

earned  but  not  collected,   169. 

going  rate  of,  188. 

determination  of  rate  of,  188-89. 

variation  of  rate  of,  188,  199. 

classes  of,  190. 

legal,  190-91. 

on  savings  deposits,  320-21. 
International       balance,      chart, 

258. 
International  relationship  among 

banks,  250-51. 
International  trade,  classical  the- 
ory of,  255. 
Inventory,  115-16. 
Investment: 

international,  factors  stimulat- 
ing, 256. 

comparison  between  direct  and 
indirect,  313-14. 

of  savings  banks,  321-26. 

in  real-estate  mortgages,  322-23. 

in  bonds,  324-25. 
Investment  bank.  Chapter  XIX. 

departments  of,  301-02. 

classes  of,  302-04. 

function  of  investigation,  304- 
05. 


function  of  underwriting,  306- 
08. 

carrying  by,  307. 

hability  of,  307-08. 

function  of  selling,  308-09. 

services  of,  309-10. 

comjiared   with  savings   bank, 
311-12. 
Investment  banking: 

classification  of,  52. 

function  of,  52. 

hi.story  of,  299-301. 

compared  with  commercial,  521- 
24. 
Investment  credit,  16,  25-27. 
Investment  trust,  52. 
Invoice: 

commercial,  273. 

consular,  273-74. 


Joint-stock   banks,  of  England, 
374. 

K 

Kern  Amendment,  69. 
Knight- Yancey  frauds,  272. 


Legal  tender,  36. 

notes  in  England,  373. 
Letter  of  credit : 

customer's  liability  under,  166. 

compared    with    authority    to 
purchase,  277. 

contract  for,  277. 

illustration  of,  277-78. 

commercial,  definition  of,  278- 
79. 

classification,  279. 

compared  with  travelers',  280. 

travelers',  280-81. 
Letters  of  hyp)othecation,  274. 
Liabilities  of  a  bank,  analysis  of, 
169,  173. 

examination  of,  221-22. 
"  Line  of  credit,"  meaning  of,  1 18. 

determination  of,  117-19. 


570 


BANKING  AND   BUSINESS 


Liquidation  of  banks,  232-33. 
Liquidity,  necessity  of,  IIL 
Loans,  handling  of,  90-91. 

distribution  of,  131-33,  135-37. 

on  farm  lands,  137-38. 

policy  determined  by,  142. 

government  restrictions  on,  142. 

to  one  interest,  144. 

real  estate,  restrictions  on,  147, 
149. 

secured,  191. 

restrictions  on,  525-26. 

interbank,  527-30. 
Loans  and  discounts: 

department  for,  90-91. 

composition  of,  165-66. 

examination  of,  220-21. 
London  clearing  banks,  statement 

of,  543. 
Loose-leaf  accoimting,  92. 

M 

Margin,  amount  of,  90. 

examination  of,  222. 
Market,  call  (See  call  market). 
Market,  discount,  361. 
Market  rates,  186. 

central  bank  and,  197-98. 
McLean  Act,  282-83. 
Membership  in   Federal  Reserve 
system : 

requirements    for    state    banks 
and  trust  companies,  453-58. 

privileges  of,  459. 

class  of  reports  required  of,  460. 

duties  and  obligations  of,  461. 

loss  of,  461. 
Metal,  specie,  supples  of  adjusted, 

485. 
Mill,  J.  S.,  in  quantity  theory,  255, 

485. 
Mint  value  of  exchange,  253. 
Money: 

functions  of,  7-8. 

relation  to  banking,  8-9,  12. 

use  of,  12. 

legal  tender,  36. 

relation  to  exchange,  478-79. 


relation  of  bank  credit  to,  478- 

80. 
prices  and  banking,  478-98. 
value  of,  480-81. 
quantity  theory  of,  stated,  484- 

87. 
quantity    theory,    J.    S.    Mill's 

definition  of,  485-86. 
paper,  kinds  of,  487-88. 
"Money  post,"  192. 
"Money  trust,"  496. 
Morris  Plan  bank;  55. 
Muhleman  bill,  422. 
Mutual  savings  bank  (See  savings 
bank) . 

N 

National    "Currency    Associa- 
tions," 421. 
National  Monetary  Commission, 
membership    and   duties   of, 
422. 
National  Bank  Act: 
requirements   of   capital   stock 

under,  63. 
requirements  of  surplus  under, 

64. 
officers,  73. 

reports  required  by,  217. 
reserve  districts  under,  227. 
provision  for  receiver  of  bank 

under,  233. 
savings  deposits  under,  328. 
principal  features  of,  406. 
amendment  to,  408. 
National  banking  system,  devel- 
opment of,  408-12. 
defects  of,  414-15. 
executive  officer  of,  467. 
National  banks: 
notes    to    be    issued    by,    407, 

413. 
to  buy  bonds,  407-08. 
Negotiabihty,  definition  of,  34. 

conditions  of,  35-37. 
"New  business"  division,  90. 
New  Hampshire,  guaranty  -  fund 
banks  of,  32S-29. 


INDEX 


571 


New  York: 

banking  law  of,  215. 

savings  deposits  limited  by,  317. 

investiner.ts   of   savings   bank.s 
in,  322-26. 
New    York   Stock    Exchange   on 

transfers,  312-43. 
North  Dakota,  Bank  of,  4G. 
Note  issue: 

by  central  banks,  370. 

increase  of,  by  Bank  of  Franco, 
377. 

of  Reichsbank,  limit  of.  379. 

Reichsbank  tax  on,  379. 

of  Canadian  banks,  limits  on, 
381. 

change  in  national  bank,  409. 

security  behind  national  bank, 
410. 
Note: 

promissory,  29. 

short-term,  44. 

tax  on,  50. 

receivable,  115. 

payable,  117. 
Numerical  transit  system,  86. 

O 

OflScers,  bank,  70-73. 

Open  account,  use  of,  109-10. 

Open  market,  meaning  of,  187-88. 

borrowing,  124. 

paper,  126. 

advantages  of,  127. 

loans  and  discounts  in,  189-90. 
Operation,  bank  {See  Chapter  VI). 
Organization  certificate,  62. 
Overdrafts,  166-79. 
Overseas  banks,  282. 


Panic  of  1907: 

effects  of,  419-20. 

relation    of,    to    government 
funds,  420. 
Paper  money: 

kinds  of,  4S7-88. 

relation  to  banking,  487-89. 


Par  of  exchange,  253. 

Paying  teller,  duties  of,  78-81. 

comparison  with  receiving  tel- 
ler, 78. 

payments  made  by,  7S. 

cashing  of  check  by,  79-80. 
TcKSonnel,  banking,  293-96. 
Philippine  National  Bank,  164. 
PortfoUo  bank: 

definition  of,  131,  133. 

contents  of,  134. 

problems  in  developing,  137-39. 

relation  to  management,  139. 

establishing  sound,   139. 

effect  of  unsound,  139—10. 

analysis  of,  141. 

promissory  notr-s  in,  149. 
Postal    savings:    reserve    against, 
227-28. 

system,  329-31. 
Preferred  stock,  42. 
Presentment: 

definition  of,  39. 

procedure  of,  39. 
President : 

member  of  board  of  directors,  70. 

duties,  71. 
Prices: 

ascertainment  of,  6. 

inflation,  relation  to  bank  infla- 
tion, 161. 

level  and  inflation,  163. 

adjustment  of,  186. 

banking  and,  489-92. 

theory  of,  496-98. 

definition  of,  497. 

monev   and   banking,    Chapter 
XXVIII. 
Prime  bills,  262. 
Private  banks,  classes  of,  48. 
Promissory  notes,  29. 
Public-service  nature  of  banking, 
recognition  of,  505-07. 

R 
Rates: 

on  loans  and  discounts,  187-88. 
legal.  190-91. 


572 


BANKING  AND  BUSINESS 


call-money,  191-92. 

on  stock  exchange,  192. 

on  acceptances,  193-94. 

adjustment  of,  194. 

central  bank,  194-95. 
Rate  of  exchange: 

meaning,  253. 

factors  determining,  253. 

effects  of  investments  on,  256. 
Rationing  of  credit,  197. 
Real-estate  loans,  restriction  on, 

147,  149. 
Receiving  teller,  76-78. 
Reconcilement  of  accounts,  77. 
Redemption  fund,  168-69,  176. 
Rediscount,  157. 

effect  of,  159. 

process,  international,  159,  172- 
73,  178. 
"Refinancing"  acceptance,  276. 
Regulation,  government.  Chapter 

XIV. 
Reichsbank : 

as  fiscal  agent,  378-79. 

control  of,  378-80. 

functions  of,  379-80. 

statement  of,  542. 
Reports,  bank,  216-17. 

"window  dressing"  of,  216-17. 

required     by    National     Bank 
Act,  217. 
Reserve:  Chapter  V. 

meaning  of,  150. 

policy,  150. 

relation  to  business,  150. 

ratio,  150,  152. 

theory  of,  150-54. 

secondary,  151. 

where  kept,  151. 

European  practice  on,  153. 

relation  to  quick  assets,  154. 

maintenance  of,  154-60. 

as    an    item    of    banking    csot, 
205-09. 

requirements,  226-28. 

computation  of,  229. 

of  member  banks,  amount  and 
where  kept,  458. 


of  members  of  Federal  Reserve 
system,  penalty  for  deficiency 
of,  460. 
Restrictions : 

on  loans,  144-48. 
on  national  bank  loans,   sum- 
marized, 149. 
Ricardo,   on  international  trade, 
255. 


"Safety-fund  plan,"  400. 
Savings  accounts,  reserve  against, 

227-28. 
Savings  banks,  Chapter  XX. 

deposits  in,  311. 

compared  with  commercial  and 
investment  banks,  311-14. 

loans,  312. 

mutual,  314-26. 

president  of,  315. 

treasurer  of,  315-16. 

departments  of,  316. 

comptroller,  316. 

deposits  of,  316-17. 

passbook,  317-21. 

making  a  deposit  in,  318. 

withdrawng    a    deposit    from, 
318-19. 

interest  on  deposits,  320-21. 

investments  of,  321-26. 

real-estate    mortgages    as    in- 
vestment for,  322-23. 

amortization  by,  324. 

investment  in  bonds,  324-25. 

short-term  investments,  325-27. 

and  call  market,  326. 

investment  in  acceptances,  326. 

stock,  327. 

savings  department,  327-28. 

classes  of,  327-31. 

guaranty-fund,  328-29. 

municipal,  330-31. 
Scotch  banking  system,  374. 
Second  Bank  of  the  United  States: 

organization  and  capital,  393- 
94. 

experience  of,  395-96. 


INDEX 


573 


Service  department,  93-94,  101. 
Settlement,  methods  of,  109-10. 
Smith,    Adam,    on    international 

trade,  255. 
Speciahzation  in  banking,  50. 
Specie : 

purchase  of,  158-60. 

resumption  of  payment,  409. 
Speculation : 

in  foreign  exchange,  257,  267- 
68. 
Standard  of  deferred  payments,  7. 
State  banks: 

types  of,  396-402. 

development  of,  396-402. 

characteristics  and  functions  of, 
401-02. 
State-owned  banks,  401-02. 
Statement  of  account,  77. 
Sterling    exchange,     investments 

and,  256-57. 
Stock : 

certificate,  41. 

preferred  shares  of,  rights  of,  42. 

examination  of,  221. 

regulation  of,  343. 
Stockholders,    rights    and    liabil- 
ities of,  65. 
Stop-payment  order,  80. 
Subscription    list,    circulation    of, 

61-02. 
Sufi'olk  Bank: 

redemption  by,  398-99. 
Supervision  by  government: 

need  of,  213. 

aim  of,  214. 

operation  of,  215-16. 
Surplus: 

requirements  of,  04. 

relation  to  loans,   144,   147-48, 
169-70. 
Syndicate,  307. 
Systeirus,  bank.  Chapter  XXII. 

T 
Terms  of  sale,  meaning  of,  108. 
"Tickler,"  87. 
Timing  of  collection  item.",  87. 


Travelers'  letter  of  credit,  280-81. 
Trust,  moaning  of,  333. 
Trust    company    (See    Chapter 
XXI). 
voluntary    tnist.s    liaiidlt'd    bv, 

3.38-41. 
as  guardian,  .340. 
testamentary  trust  of,  handled 

by,  340-41. 
as  executor,  341. 
as  administrator,  341. 
as  syndicate  member  or  man- 
ager, 341-42. 
as  tran.sfer  agent,  342. 
as  registrar,  342-43. 
as  trustee  under  corporate  mort- 
gage, 343-45. 
depository  under  reorganization 

agreement,  346. 
as  agent  in  escrow,  346. 
as  assignee  and  receiver,  347-48. 
regulation  of,  348-49. 
Trust  receipt,  488. 
Trustees  of  savings  banks,  314-15. 


U 


Underwriting,  306-08. 
Undivided  profits,  170. 
"Unit"  system,  81. 
Usury  laws,  190. 


Value: 

standard  of,  7. 

store  of,  8. 

of  money,  481-S4. 
Vice-president,  selection   and  du- 
ties, 72. 
Vrceland  bill,  421. 

W 

War  Finance  Corporation,  476. 
Warehouse  receipt,  29,  488. 
"Window  dressing,"  216. 


Yokohama  Specie  Hank,  .385. 


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